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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