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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