ISLMISLM Analysis of Analysis ofthe Open Economythe Open Economy((ISLMBP ISLMBP Analysis)Analysis)

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Fixed exchange rates:The BP curve

Fixed exchange rates:The BP curve

O

r

Y

r1

SURPLUS

DEFICIT

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

SURPLUS

DEFICIT

Y1

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Assume that nationalincome rises

Y1

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Y1

Assume that nationalincome rises

Deficit if rate of interestremains at r1

b

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

r1

Y1

a

Y1

Rate of interest mustrise to r2 to restore

balance of payments

cr2

BP

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Full equilibrium in thegoods, money andforeign exchange

markets

Full equilibrium in thegoods, money andforeign exchange

markets

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

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

a

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Effect of an expansionaryfiscal policyunder fixed

exchange rates

Effect of an expansionaryfiscal policyunder fixed

exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

r1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

a

r2

Y2

b

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

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS1

ar1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

r2

b

Y2

Restoration of

full equilibrium

LM2

r3

Y3

c

ISLMBP analysis: fixed exchange ratesISLMBP 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

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

a

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

r2

b

Y2

ISLMBP analysis: fixed exchange ratesISLMBP 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

r2

b

Y2

Balance of paymentsdeficit causes money

supply to contract

ISLMBP analysis: fixed exchange ratesISLMBP 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

r2

b

Y2

Restoration of

full equilibrium

LM2

r3

Y3

c

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Effect of an expansionarymonetary policy

under fixed exchange rates

Effect of an expansionarymonetary policy

under fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy

LM2

Y2

r2

b

ISLMBP analysis: fixed exchange ratesISLMBP 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

ISLMBP analysis: fixed exchange ratesISLMBP 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

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Floating exchange rates:The BP curve

Floating exchange rates:The BP curve

O

r

Y

BP

SURPLUS

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

Appreciation

O

r

Y

BP

DEFICIT

Depreciation

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Effect of an expansionaryfiscal policy

under floatingexchange rates

Effect of an expansionaryfiscal policy

under floatingexchange rates

O

r

Y

BP

LM

IS1

Y1

An expansionary fiscal policyAn expansionary fiscal policy

IS2

Y2

r1

r2

b

a

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

ISLMBP analysis: fixed exchange ratesISLMBP analysis: fixed exchange rates

Effect of an expansionarymonetary policyunder floating

exchange rates

Effect of an expansionarymonetary policyunder floating

exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2

BP1

LM2

b

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2 b

The balance of paymentsdeficit causes the BP line

to shift downward

BP1

LM2

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates

O

r

Y

LM1

IS1

Y1

An expansionary monetary policyAn expansionary monetary policy

a

Y2

r1

r2 b

The depreciationcauses the IS curveto shift to the right

BP1

LM2

ISLMBP analysis: floating exchange ratesISLMBP 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

ISLMBP analysis: floating exchange ratesISLMBP analysis: floating exchange rates