Fixed exchange rates:Fixed exchange rates:

TheThe BP BP curve curve

IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates

O

r

Y

r1SURPLUS

DEFICIT

IS-LM-BP analysis: fixed exchange rates

BP

Zero Capital Flows

O

r

Y

r1SURPLUS

DEFICIT

BP

IS-LM-BP analysis: fixed exchange rates

Restricted Capital Flows

O

r

Y

SURPLUS

DEFICIT

Y1

BP

IS-LM-BP analysis: fixed exchange rates

Restricted Capital Flows

O

r

Y

r1

IS-LM-BP analysis: fixed exchange rates

Unrestricted Capital Flows

BP

DEFICIT

SURPLUS

O

r

Y

r1

Y1

a

BP

IS-LM-BP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Assume that nationalincome rises

Y2

BP

IS-LM-BP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Y2

Assume that nationalincome rises

Deficit if rate of interestremains at r1

b

BP

IS-LM-BP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Y2

Rate of interest mustrise to r2 to restore

balance of payments

cr2

BP

IS-LM-BP analysis: fixed exchange rates

Full equilibrium in theFull equilibrium in thegoods, money andgoods, money and

foreign exchange marketsforeign exchange markets

IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates

O

r

Y

BP

LM

IS

r1

Y1

Full equilibrium in the goods, moneyFull equilibrium in the goods, moneyand foreign exchange marketsand foreign exchange markets

IS-LM-BP analysis: fixed exchange rates

a

Effect of an expansionaryEffect of an expansionaryfiscal policyfiscal policy

under fixed exchange ratesunder fixed exchange rates

IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

a

r2

Y2

b

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

ar1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

r2

b

Y2

Balance of paymentssurplus causes money

supply to expand

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

ar1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

r2

b

Y2

Restoration offull equilibrium

LM2

r3

Y3

c

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

IS2

a

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

IS2

ar2

b

Y2

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

IS2

ar2

b

Y2

Balance of paymentsdeficit causes money

supply to contract

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

IS2

ar2

b

Y2

Restoration offull equilibrium

LM2

r3

Y3

c

Effect of an expansionaryEffect of an expansionarymonetary policymonetary policy

under fixed exchange ratesunder fixed exchange rates

IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

LM2

Y2

r2

b

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

Y2

LM2

r2

bBalance of paymentsdeficit causes money

supply to contract again

IS-LM-BP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

Y2

LM2

r2

bFull equilibrium

is restoredback at point a

Floating exchange rates:Floating exchange rates:

TheThe BP BP curve curve

IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

SURPLUS

O

r

Y

BP

SURPLUSAppreciation

IS-LM-BP analysis: floating exchange rates

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

DEFICIT

O

r

Y

BP

DEFICIT

Depreciation

IS-LM-BP analysis: floating exchange rates

Effect of an expansionaryEffect of an expansionaryfiscal policyfiscal policy

under floating exchange ratesunder floating exchange rates

IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

LM

IS1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

Y2

r1

r2

b

a

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

LM

IS1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

a

Y2

r1

r2

b

Balance of paymentssurplus causes the

exchange rate to appreciate

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

LM

IS1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

a

Y2

r1

r2

b

The appreciationcauses the IS curve

to shift to the left

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP1

LM

IS1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

a

Y2

r1

r2

b

Full equilibrium isrestored at point c

BP2

IS3

Y3

r3

c

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM

BP1

IS1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

ar1

IS2

Y2

r2b

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM

BP1

IS1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

a

Y2

r1

r2b

IS2

Balance of paymentsdeficit causes exchange

rate to depreciate

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM

BP1

IS1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

a

Y2

r1

r2b

IS2

Depreciation causesthe IS curve toshift to the right

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM

BP1

IS1

Y1

An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve

IS3

a

Y2

r1

r2b

BP2

IS2

Y3

r3c

Full equilibrium isachieved at point c

Effect of an expansionaryEffect of an expansionarymonetary policymonetary policy

under floating exchange ratesunder floating exchange rates

IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2

BP1

LM2

b

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2 bThe balance of paymentsdeficit causes the BP line

to shift downward

BP1

LM2

IS-LM-BP analysis: floating exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2 bThe depreciation

causes the IS curveto shift to the right

BP1

LM2

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP2

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2 b Full equilibrium isrestored at point c

BP1

IS2

Y3

r3

LM2

c