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Balance of Payments
and Exchange Rates
Balance of Payments and Exchange Rates
Alternative Exchange
Rate Regimes
ALTERNATIVE EXCHANGE RATE REGIMES
• Internal and external policy objectives
– internal balance
– external balance
• narrow sense: current account balance
• broad sense: total currency flow balance
Internal and external balance
W, J
(a) Internal balance
W1
J1
O
YF
Ye1
National income
Internal and external balance
Exchange rate
(b) External balance
r1
S1 by UK
Fixed
exchange rate
D by overseas
residents
O
Quantity of £s
ALTERNATIVE EXCHANGE RATE REGIMES
• Internal and external policy objectives
– internal balance
– external balance
• narrow sense: current account balance
• broad sense: total currency flow balance
– possible conflicts between internal and
external objectives
Internal and external balance
W, J
Assume that initially there
is internal imbalance: at Ye2
W2
W1
J1
J2
O
Ye2
YF
Ye1
National income
Internal and external balance
W, J
Assume that the government
increases aggregate demand
to achieve internal balance.
W2
W1
J1
J2
O
Ye2
YF
Ye1
National income
Internal and external balance
Exchange rate
This creates
external imbalance:
i.e. currency flow deficit
r1
S1 by UK
S2 by UK
Fixed
exchange rate
D by overseas
residents
O
Quantity of £s
Internal and external balance
S1 by UK
Exchange rate
S2 by UK
r1
r2
Or an imbalance in the narrow sense
(a current account deficit) under a
floating exchange rate
D by overseas
residents
O
Quantity of £s
Effects on internal and (narrow) external balance
Current account surplus
2
1
balance
Contractionary fiscal policy
Lower consumption
Exchange rate depreciation
Foreign boom
Recession
External
Internal balance
Exchange rate appreciation
Foreign recession
Boom
Expansionary fiscal policy
Higher consumption
4
3
Current account deficit
UK balance of payments as % of GDP, 1970–2007
Source: Financial Statement and Budget Report (H M Treasury, 2005)
ALTERNATIVE EXCHANGE RATE REGIMES
• Internal and external policy objectives
– internal balance
– external balance
• narrow sense: current account balance
• broad sense: total currency flow balance
– possible conflicts between internal and
external objectives
• Nominal and real exchange rates
ALTERNATIVE EXCHANGE RATE REGIMES
• Internal and external policy objectives
– internal balance
– external balance
• narrow sense: current account balance
• broad sense: total currency flow balance
– possible conflicts between internal and
external objectives
• Nominal and real exchange rates
– real exchange rate index
• RERI = NERI × PX / PM
Sterling nominal and real exchange rate indices
(1990 = 100)
140
130
120
110
100
90
80
1986
1988
1990
1992
1994
1996
1998
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
2000
2002
2004
Sterling nominal and real exchange rate indices
(1990 = 100)
140
130
120
110
Nominal
exchange rate
100
90
80
1986
1988
1990
1992
1994
1996
1998
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
2000
2002
2004
Sterling nominal and real exchange rate indices
(1990 = 100)
140
130
120
110
Nominal
exchange rate
100
90
80
1986
1988
1990
1992
1994
1996
1998
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
2000
2002
2004
Sterling nominal and real exchange rate indices
(1990 = 100)
140
130
Real
exchange rate
120
110
Nominal
exchange rate
100
90
80
1986
1988
1990
1992
1994
1996
1998
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
2000
2002
2004
Sterling nominal and real exchange rate indices
(1990 = 100)
140
130
Real
exchange rate
120
110
Nominal
exchange rate
100
90
80
1986
1988
1990
1992
1994
1996
1998
Source: based on data in Interactive Database (Bank of England) and International Statistics (IMF)
2000
2002
2004
ALTERNATIVE EXCHANGE RATE REGIMES
• Alternative exchange rate regimes
– completely fixed
(a) Total currency flow deficit
Exchange rate
S by UK
b
a
Fixed rate
D from abroad
O
Quantity of £s
(b) Total currency flow surplus
Exchange rate
S by UK
d
c
Fixed rate
D from abroad
O
Quantity of £s
ALTERNATIVE EXCHANGE RATE REGIMES
• Alternative exchange rate regimes
– completely fixed
– freely floating
ALTERNATIVE EXCHANGE RATE REGIMES
• Alternative exchange rate regimes
– completely fixed
– freely floating
– intermediate
ALTERNATIVE EXCHANGE RATE REGIMES
• Fixed exchange rates
– foreign exchange intervention
• effects on the money supply
• sterilisation
– correcting a disequilibrium
• expenditure reducing
• expenditure switching
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
Adjustment of the exchange rate to a shift in demand and supply
Exchange rate
S1
S2
er1
Depreciation
er2
D2
O
Quantity of £s
D1
Adjustment of the exchange rate to a shift in demand and supply
S3
S1
Exchange rate
er3
Appreciation
er1
D3
D1
O
Quantity of £s
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
• elasticities of currency demand and supply
Supply of pounds and the elasticity of demand for imports
Exchange rate
S
Elastic demand
for imports
O
Quantity of £s
Exchange rate
Supply of pounds and the elasticity of demand for imports
Inelastic demand
for imports
S
O
Quantity of £s
Exchange rate
Unstable equilibrium
r
D
O
Quantity of £s
S
Exchange rate
Unstable equilibrium
r
D
O
Quantity of £s
S
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
• elasticities of currency demand and supply
• the Marshall–Lerner condition
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
• elasticities of currency demand and supply
• the Marshall–Lerner condition
– expenditure changing (the income effect)
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
• elasticities of currency demand and supply
• the Marshall–Lerner condition
– expenditure changing (the income effect)
• a rise in income
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E1
Current account
deficit of a – b
O
a
Y1
Y
b
(X – M)1
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E1
Exchange rate
depreciates
O
a
Y1
Y
b
(X – M)1
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E1
Exports rise;
imports fall
O
a
Y1
Y
b
(X – M)1
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E1
Expenditure
rises
O
a
Y1
Y
b
(X – M)1
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E1
Income effect
Exports fall back somewhat;
imports rise back somewhat
O
a
Y1
Y
b
(X – M)1
The income effect (stable prices)
Expenditure (E), exports (X), imports (M)
Y
E2
E1
Eventual equilibrium (Y2)
Positive substitution effect: c – b
Negative income effect: c – a
Net balance of payments effect: a – b
O
c
a
Y1
b
Y2
(X – M)2
(X – M)1
Y
ALTERNATIVE EXCHANGE RATE REGIMES
• Free-floating exchange rates
– automatic correction
– expenditure switching (the substitution
effect)
• the process of adjustment
• elasticities of currency demand and supply
• the Marshall–Lerner condition
– expenditure changing (the income effect)
• a rise in income
• a rise in prices
ALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
The crawling peg within exchange rate bands
Exchange rate
$1.60
$1.40
O
No
intervention
Central bank
Central bank
No
buys domestic intervention sells domestic
currency
currency
No
intervention
Time
ALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
ALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
– exchange rate bands
ALTERNATIVE EXCHANGE RATE REGIMES
• Intermediate exchange rate regimes
– adjustable peg
– dirty floating
– crawling peg
– joint float
– exchange rate bands
• exchange rate bands under the old ERM
Balance of Payments and Exchange Rates
Fixed Exchange Rates
FIXED EXCHANGE RATES
• Response to contractionary internal shock
– short-run effect
• assumption: relatively inflexible wages & prices
• effects of reduced aggregate demand
– current account surplus
– reduced interest rates  financial account deficit
• financial account effect likely to be the bigger
• to prevent exchange rate falling, the interest
rate must thus not be allowed to fall so far
– money supply must be allowed to contract to match
the fall in demand for money
– internal imbalance will persist
FIXED EXCHANGE RATES
• Response to contractionary internal shock
– long-run effect
• assume: greater flexibility of wages & prices
– this allows internal balance to be restored
• external effects of reduced AD
– large current account surplus from fall in real
exchange rate
– reduced somewhat by the rise again in aggregate
demand from higher exports and lower imports
• overall external balance restored
• current account surplus may persist
FIXED EXCHANGE RATES
• Response to contractionary external shock
– short-run effect
• assumption: fall in exports
• current account deficit
– fall in X  fall in AD  fall in M
• financial account
– fall in AD  fall in r
– if r is allowed to fall  financial account deficit
– money supply must be reduced to prevent this
happening  this allows r to rise
• rise in r makes recession worse
FIXED EXCHANGE RATES
• Response to contractionary external shock
– long-run effect
• assumption: fall in exports
• reduction in AD reduces inflation
• this reduces real exchange rate
• current account deficit is eliminated
• flexible prices restore internal balance too
• but the ‘long term’ may be very long in coming!
FIXED EXCHANGE RATES
• Effectiveness of government policies
– monetary policy
• relatively ineffective
– fiscal policy
• relatively effective
• Causes of balance of payments
problems under fixed rates
– different rates of inflation
– different rates of growth
– income elasticities of demand for imports
higher than for exports
– long-term structural changes
FIXED EXCHANGE RATES
• Advantages of fixed exchange rates
– certainty
– no speculation (if rate is absolutely fixed)
– automatic correction of monetary errors
– prevents ‘irresponsible’ government
policies
FIXED EXCHANGE RATES
• Disadvantages of fixed exchange rates
– new classical view
• make monetary policy ineffective
• anti free market
– Keynesian view
• balance of payments deficits can lead to
recession
• possibility of competitive deflation
• problems of international liquidity
• inability to adjust to shocks
• speculation
Balance of Payments and Exchange Rates
Free-floating Exchange
Rates
FREE-FLOATING RATES
• Response to shocks
– internal shocks
• purchasing-power parity theory
• limitations of theory in short run
– changes in interest rates affect financial account
– this affects current account in opposite direction
– external shocks
• changes in exchange rate help to insulate
domestic economy from such shocks
– the path to long-run equilibrium
Nominal exchange rate
Exchange rate path to long-run equilibrium
after a shock at time t1
er1
Exchange
rate path
erL
O
t1
Time
Nominal exchange rate
Exchange rate path to long-run equilibrium
after a shock at time t1
er1
Exchange
rate path
erL
O
t1
t2
Time
FREE-FLOATING RATES
• Speculation
– stabilising speculation
Stabilising speculation
S1
S3
S2
Exchange rate
er1
People believe that
exchange rate change
is only temporary.
er3
er2
D1
D2
O
Quantity of £s
D3
FREE-FLOATING RATES
• Speculation
– stabilising speculation
– destabilising speculation
Destabilising speculation
S1
S2
S3
Exchange rate
er1
People believe that
exchange rate change
indicates a trend.
er2
er3
D1
D3
O
Quantity of £s
D2
FREE-FLOATING RATES
• Speculation
– stabilising speculation
– destabilising speculation
• overshooting
FREE-FLOATING RATES
• Effectiveness of government policy
– monetary policy
• relatively effective
– direct effect on aggregate demand
– reinforced by a change in the exchange rate
• effect of speculation
– fiscal policy
• relatively ineffective
– direct effect on aggregate demand
– offset by effect on interest rates & exchange rate
FREE-FLOATING RATES
• Advantages of free-floating rates
– automatic correction
• no problem of international liquidity and reserves
– insulation from external events
– governments free to pursue domestic policy
• Disadvantages of free-floating rates
– unstable exchange rates
Fluctuations between the euro and the dollar
1.35
1.30
6
1.25
5
1.20
1.15
US$ / €
1.10
1.05
3
1.00
2
0.95
0.90
1
0.85
0.80
1999
0
2000
2001
2002
2003
2004
2005
Interest rate
4
Fluctuations between the euro and the dollar
1.35
1.30
US interest
rate
1.25
6
5
1.20
1.15
US$ / €
1.10
1.05
3
1.00
2
0.95
0.90
1
0.85
0.80
1999
0
2000
2001
2002
2003
2004
2005
Interest rate
4
Fluctuations between the euro and the dollar
1.35
1.30
US interest
rate
1.25
6
5
1.20
4
ECB
interest rate
1.10
1.05
3
1.00
2
0.95
0.90
1
0.85
0.80
1999
0
2000
2001
2002
2003
2004
2005
Interest rate
US$ / €
1.15
Fluctuations between the euro and the dollar
1.35
1.30
US interest
rate
1.25
6
5
1.20
4
ECB
interest rate
1.10
1.05
3
1.00
2
0.95
0.90
1
0.85
0.80
1999
0
2000
2001
2002
2003
2004
2005
Interest rate
US$ /€
1.15
Fluctuations between the euro and the dollar
1.35
1.30
US interest
rate
1.25
6
$/€
5
1.20
4
ECB
interest rate
1.10
1.05
3
1.00
2
0.95
0.90
1
0.85
0.80
1999
0
2000
2001
2002
2003
2004
2005
Interest rate
US$ / €
1.15
FREE-FLOATING RATES
• Advantages of free-floating rates
– automatic correction
• no problem of international liquidity and reserves
– insulation from external events
– governments free to pursue domestic policy
• Disadvantages of free-floating rates
– unstable exchange rates
– speculation
FREE-FLOATING RATES
• Advantages of free-floating rates
– automatic correction
• no problem of international liquidity and reserves
– insulation from external events
– governments free to pursue domestic policy
• Disadvantages of free-floating rates
– unstable exchange rates
– speculation
– uncertainty for business
FREE-FLOATING RATES
• Advantages of free-floating rates
– automatic correction
• no problem of international liquidity and reserves
– insulation from external events
– governments free to pursue domestic policy
• Disadvantages of free-floating rates
– unstable exchange rates
– speculation
– uncertainty for business
– lack of discipline on economy
Balance of Payments and Exchange Rates
Exchange Rate
Systems in Practice
EXCHANGE RATE SYSTEMS IN PRACTICE
• The Bretton Woods system (1943–73)
– the system
• role of the IMF
• correction through deflation or reflation
• correction through devaluation or revaluation
– Problems of adjustment
• disruption of devaluations
• J-curve effect of devaluation
The J-curve effect
X-M
Devaluation takes
place at t1
Surplus
0
Deficit
t1
Time
EXCHANGE RATE SYSTEMS IN PRACTICE
• The Bretton Woods system (1943–73)
– the system
• role of the IMF
• correction through deflation or reflation
• correction through devaluation or revaluation
– Problems of adjustment
• disruption of devaluations
• J-curve effect of devaluation
• stop–go policies
EXCHANGE RATE SYSTEMS IN PRACTICE
• The Bretton Woods system (1943–73)
– the system
• role of the IMF
• correction through deflation or reflation
• correction through devaluation or revaluation
– Problems of adjustment
• disruption of devaluations
• J-curve effect of devaluation
• stop–go policies
• speculation
EXCHANGE RATE SYSTEMS IN PRACTICE
• The Bretton Woods system (cont.)
– problems of international liquidity
• over-reliance on US dollar
• problem of US deficits and excess liquidity
– decline in confidence in the system
– the collapse of the system
EXCHANGE RATE SYSTEMS IN PRACTICE
• Managed floating: 1972 onwards
– forms of managed flexibility
• extent of intervention
• forms of intervention
– justification of managed floating
• focus on long-term equilibrium exchange rate
• adjustment is less disruptive
• Problems with managed floating
– predicting the long-term equilibrium rate
– speculative financial movements
– conflicts with internal policy
Exchange rate indices
averages for each period (1995 = 100)
1970-3 1974-7 1978-81 1982-5 1986-9 1990-3 1994-6 1997-9 2000–2 2003-5
USA
61
58
57
80
77
86
101
121
133
124
Japan
17
19
25
30
51
64
94
90
96
91
Germany
36
44
53
58
71
82
97
98
94
103
UK
163
122
118
113
106
107
102
125
129
128
Italy
256
181
134
112
113
118
106
113
112
122
Based on data in European Economy Statistical Annex (Commission of the European Union)
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
$ / £ exchange rate and £ exchange rate index: 1976–2005
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
$ / £ exchange rate and £ exchange rate index: 1976–2005
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6 6
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
– joining and leaving the ERM
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
– joining and leaving the ERM
– sterling in the mid 1990s
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
– joining and leaving the ERM
– sterling in the mid 1990s
– recent experience
$ / £ exchange rate and £ exchange rate index: 1976–2005
Index
1990=100
$/£
$2.40
150
$2.20
140
130
$2.00
120
$1.80
110
$1.60
100
$1.40
90
$1.20
$1.00
1975
80
1980
1985
1990
1995
2000
70
2005
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
– joining and leaving the ERM
– sterling in the mid 1990s
– recent experience
• problems of a high pound
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of managed floating
– effects of first oil crisis: 1973–6
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits
in the 1980s
– the 1985 exchange crisis
– joining and leaving the ERM
– sterling in the mid 1990s
– recent experience
• problems of a high pound
• exchange rate effects of inflation targeting
EXCHANGE RATE SYSTEMS IN PRACTICE
• The volatility of exchange rates
– causes of volatility
• money supply and inflation targets
• growth in financial movements
• abolition of exchange controls
• growth in IT
• growth in speculative activity
• growing belief that governments are powerless
to prevent speculation
Balance of Payments and Exchange Rates
The Open Economy and
ISLM Analysis
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
The BP curve
r
BP
r1
SURPLUS
DEFICIT
O
Y
The BP curve
r
SURPLUS
BP
DEFICIT
O
Y1
Y
The BP curve
r
BP
r1
a
O
Y1
Y
The BP curve
r
Assume that national
income rises
BP
r1
a
O
Y1
Y1
Y
The BP curve
r
Assume that national
income rises
BP
r1
a
O
Y1
b
Y1
Deficit if rate of interest
remains at r1
Y
The BP curve
r
BP
c
r2
r1
a
O
Y1
Rate of interest must
rise to r2 to restore
balance of payments
Y1
Y
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
ISLMBP analysis: fixed exchange rates
r
LM
BP
r1
a
IS
O
Y1
Full equilibrium in the goods, money
and foreign exchange markets
Y
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
– effects of fiscal policy
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
LM2
b
r2
r3
r1
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
Balance of payments
deficit causes money
supply to contract
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
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
THE OPEN ECONOMY AND ISLM ANALYSIS
• The BP curve
• Analysis under a fixed exchange rate
– equilibrium in the model
– movement to a new equilibrium
– effects of fiscal policy
– effects of monetary policy
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
THE OPEN ECONOMY AND ISLM ANALYSIS
• Analysis under free-floating rates
– effects of exchange rate changes on the
BP curve
Movements in the BP curve
r
Appreciation
SURPLUS
BP
O
Y
Movements in the BP curve
r
BP
Depreciation
DEFICIT
O
Y
THE OPEN ECONOMY AND ISLM ANALYSIS
• Analysis under free-floating rates
– effects of exchange rate changes on the
BP curve
– achievement of equilibrium
THE OPEN ECONOMY AND ISLM ANALYSIS
• Analysis under free-floating rates
– effects of exchange rate changes on the
BP curve
– achievement of equilibrium
– effects of fiscal policy
ISLMBP analysis: floating exchange rates
r
LM
b
r
BP
2
r
a
1
IS2
IS1
O
Y1
Y2
An expansionary fiscal policy
Y
ISLMBP analysis: floating exchange rates
r
LM
b
r
BP
2
r
a
1
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
r
BP
2
r
The appreciation
causes the IS curve
to shift to the left
a
1
IS1
O
Y1
Y2
An expansionary fiscal policy
IS2
Y
ISLMBP analysis: floating exchange rates
r
LM
BP2
BP1
b
r
c
2
r
3
r
Full equilibrium is
restored at point c
a
1
IS2
IS3
IS1
O
Y1
Y3 Y2
An expansionary fiscal policy
Y
ISLMBP analysis: floating exchange rates
r
BP1
LM
r
r
2
a
b
1
IS2
IS1
O
Y1
Y2
An expansionary fiscal policy:
BP curve steeper than LM curve
Y
ISLMBP analysis: floating exchange rates
r
BP1
LM
r
r
2
a
b
1
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
r
r
2
a
b
1
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
BP1
BP2
LM
r
3r
r
2
c
a
b
Full equilibrium is
achieved at point c
1
IS3
IS2
IS1
O
Y1
Y2
Y3
An expansionary fiscal policy:
BP curve steeper than LM curve
Y
THE OPEN ECONOMY AND ISLM ANALYSIS
• Analysis under free-floating rates
– effects of exchange rate changes on the
BP curve
– achievement of equilibrium
– effects of fiscal policy
– effects of monetary policy
ISLMBP analysis: floating exchange rates
r
LM1
LM2
BP1
r
a
1
r
b
2
IS1
O
Y1
Y2
An expansionary monetary policy
Y
ISLMBP analysis: floating exchange rates
r
LM1
LM2
BP1
r
a
1
r
b
2
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
r
a
1
r
b
2
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
r
1r
BP2
a
c
3
r
b
2
Full equilibrium is
restored at point c
IS2
IS1
O
Y1
Y2 Y3
An expansionary monetary policy
Y