Is Lm Bp Analysis

ISLM Analysis of the Open Economy (ISLMBP Analysis)

ISLMBP analysis: fixed exchange rates

Fixed exchange rates: The BP curve

ISLMBP analysis: fixed exchange rates r

BP r1

SURPLUS DEFICIT

O

Y

ISLMBP analysis: fixed exchange rates r

SURPLUS

BP

DEFICIT

O

Y1

Y

ISLMBP analysis: fixed exchange rates r

BP

r1

a

O

Y1

Y

ISLMBP analysis: fixed exchange rates r Assume that national income rises

BP

r1

a

O

Y1

Y1

Y

ISLMBP analysis: fixed exchange rates r Assume that national income rises

BP

r1

a

b

O

Y1

Y1

Deficit if rate of interest remains at r1

Y

ISLMBP analysis: fixed exchange rates r

BP c

r2 r1

a

O

Y1

Rate of interest must rise to r2 to restore balance of payments

Y1

Y

ISLMBP analysis: fixed exchange rates

Full equilibrium in the goods, money and foreign exchange markets

ISLMBP analysis: fixed exchange rates r

LM

BP r1

a

IS O

Y1 Full equilibrium in the goods, money and foreign exchange markets

Y

ISLMBP analysis: fixed exchange rates

Effect of an expansionary fiscal policy under fixed exchange rates

ISLMBP analysis: fixed exchange rates r

LM1 b

r2

r1

BP a

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy

Y

ISLMBP analysis: fixed exchange rates r

LM1 b

r2

r1

BP Balance of payments surplus causes money supply to expand

a

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy

Y

ISLMBP analysis: fixed exchange rates r

LM1 b

r2 r3 r1

LM2

BP c Restoration of full equilibrium

a

IS2 IS1 O

Y1

Y2

Y3

An expansionary fiscal policy

Y

ISLMBP analysis: fixed exchange rates r

BP LM1

r1

a

IS2 IS1 O

Y1

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: fixed exchange rates r

BP LM1 b

r2 r1

a

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: fixed exchange rates r

BP LM1 b

r2 r1

a

Balance of payments deficit causes money supply to contract

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: fixed exchange rates r

BP

LM1

c

r3

b

r2 r1

LM2

Restoration of full equilibrium

a

IS2 IS1 O

Y1

Y3

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: fixed exchange rates

Effect of an expansionary monetary policy under fixed exchange rates

ISLMBP analysis: fixed exchange rates r

LM1

BP r1

a

IS O

Y1

An expansionary monetary policy

Y

ISLMBP analysis: fixed exchange rates r

LM1

LM2

BP r1

a b

r2

IS O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: fixed exchange rates r

LM1

LM2

BP r1

a b

r2

Balance of payments deficit causes money supply to contract again

IS O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: fixed exchange rates r

LM1

LM2

BP r1

a b

r2

Full equilibrium is restored back at point a

IS O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: fixed exchange rates

Floating exchange rates: The BP curve

ISLMBP analysis: floating exchange rates r SURPLUS

Appreciation BP

O

Y

ISLMBP analysis: floating exchange rates r

BP

Depreciation DEFICIT

O

Y

ISLMBP analysis: fixed exchange rates

Effect of an expansionary fiscal policy under floating exchange rates

ISLMBP analysis: floating exchange rates r

LM b

r2 r1

BP

a

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy

Y

ISLMBP analysis: floating exchange rates r

LM b

r2 r1

BP

a

IS1

IS2

Balance of payments surplus causes the exchange rate to appreciate O

Y1

Y2

An expansionary fiscal policy

Y

ISLMBP analysis: floating exchange rates r

LM b

r2 r1

BP The appreciation causes the IS curve to shift to the left

a

IS1

O

Y1

Y2

An expansionary fiscal policy

IS2

Y

ISLMBP analysis: floating exchange rates r

LM

r2

c

r3 r1

BP2 BP1

b

Full equilibrium is restored at point c

a

IS2 IS3 IS1 O

Y1

Y3 Y2

An expansionary fiscal policy

Y

ISLMBP analysis: floating exchange rates r

BP1

LM r2 r1

a

b

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: floating exchange rates r

BP1

LM r2 r1

a

b

Balance of payments deficit causes exchange rate to depreciate

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: floating exchange rates r

BP1

LM r2 r1

a

b

Depreciation causes the IS curve to shift to the right

IS2 IS1 O

Y1

Y2

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: floating exchange rates r

r3 r2 r1

BP1

a

b

c

BP2 LM Full equilibrium is achieved at point c

IS3 IS2 IS1 O

Y1

Y2

Y3

An expansionary fiscal policy: BP curve steeper than LM curve

Y

ISLMBP analysis: fixed exchange rates

Effect of an expansionary monetary policy under floating exchange rates

ISLMBP analysis: floating exchange rates r

LM1 LM2 BP1

r1

a

r2

b

IS1 O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: floating exchange rates r

LM1 LM2 BP1

r1

a

r2

b

The balance of payments deficit causes the BP line to shift downward

IS1 O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: floating exchange rates r

LM1 LM2 BP1

r1

a

r2

b

The depreciation causes the IS curve to shift to the right

IS1 O

Y1

Y2

An expansionary monetary policy

Y

ISLMBP analysis: floating exchange rates r

LM1 LM2 BP1

r1 r3

a

r2

BP2

c b

Full equilibrium is restored at point c

IS2 IS1 O

Y1

Y2 Y3

An expansionary monetary policy

Y