Fixed exchange rates: The BP curve

Fixed exchange rates:Fixed exchange rates:

TheThe BP BP curve curve

Fixed exchange rates:Fixed exchange rates:


IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates

O

r

Y

r1

SURPLUS

DEFICIT

IS-LM-BP analysis: fixed exchange ratesIS-LM-BP analysis: fixed exchange rates

BP

Zero Capital Flows

O

r

Y

r1

SURPLUS

DEFICIT

BP


Restricted Capital Flows

O

r

Y

SURPLUS

DEFICIT

Y1

BP


Restricted Capital Flows

O

r

Y

r1


Unrestricted Capital Flows

BP

DEFICIT

SURPLUS

O

r

Y

r1

Y1

a

BP


O

r

Y

r1

Y1

a

Assume that nationalincome rises

Y2

BP


O

r

Y

r1

Y1

a

Y2

Assume that nationalincome rises

Deficit if rate of interestremains at r1

b

BP


O

r

Y

r1

Y1

a

Y2

Rate of interest mustrise to r2 to restore

balance of payments

cr2

BP


Full equilibrium in theFull equilibrium in thegoods, money andgoods, money and

foreign exchange marketsforeign exchange markets

Full equilibrium in theFull equilibrium in thegoods, money andgoods, money and

foreign exchange marketsforeign 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


a

Effect of an expansionaryEffect of an expansionaryfiscal policyfiscal policy

under fixed exchange ratesunder fixed exchange rates




IS-LM-BP 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


IS2

r2

b

Y2

Balance of paymentssurplus causes money

supply to expand


O

r

Y

BP

LM1

IS1

ar1

Y1


IS2

r2

b

Y2

Restoration of

full equilibrium

LM2

r3

Y3

c


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


O

r

Y

BP

LM1

IS1

r1

Y1


IS2

a

r2

b

Y2


O

r

Y

BP

LM1

IS1

r1

Y1


IS2

a

r2

b

Y2

Balance of paymentsdeficit causes money

supply to contract


O

r

Y

BP

LM1

IS1

r1

Y1


IS2

a

r2

b

Y2

Restoration of

full equilibrium

LM2

r3

Y3

c

Effect of an expansionaryEffect of an expansionarymonetary policymonetary policy






O

r

Y

BP

LM1

IS

ar1

Y1

An expansionary monetary policyAn expansionary monetary policy


O

r

Y

BP

LM1

IS

ar1

Y1


LM2

Y2

r2

b


O

r

Y

BP

LM1

IS

ar1

Y1


Y2

LM2

r2

bBalance of paymentsdeficit causes money

supply to contract again


O

r

Y

BP

LM1

IS

ar1

Y1


Y2

LM2

r2

bFull equilibrium

is restoredback at point a

Floating exchange rates:Floating exchange rates:


Floating exchange rates:Floating exchange rates:


IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates

IS-LM-BP analysis: floating exchange rates

O

r

Y

BP

SURPLUS

O

r

Y

BP

SURPLUSAppreciation

IS-LM-BP analysis: floating exchange ratesIS-LM-BP analysis: floating exchange rates


O

r

Y

BP

DEFICIT

O

r

Y

BP

DEFICIT

Depreciation

IS-LM-BP analysis: floating exchange ratesIS-LM-BP analysis: floating exchange rates


under floating exchange ratesunder floating exchange rates





O

r

Y

BP

LM

IS1

Y1


IS2

Y2

r1

r2

b

a


O

r

Y

BP

LM

IS1

Y1


IS2

a

Y2

r1

r2

b

Balance of paymentssurplus causes the

exchange rate to appreciate


O

r

Y

BP

LM

IS1

Y1


IS2

a

Y2

r1

r2

b

The appreciationcauses the IS curve

to shift to the left


O

r

Y

BP1

LM

IS1

Y1


IS2

a

Y2

r1

r2

b

Full equilibrium isrestored at point c

BP2

IS3

Y3

r3

c


O

r

Y

LM

BP1

IS1

Y1


ar1

IS2

Y2

r2b


O

r

Y

LM

BP1

IS1

Y1


a

Y2

r1

r2b

IS2

Balance of paymentsdeficit causes exchange

rate to depreciate


O

r

Y

LM

BP1

IS1

Y1


a

Y2

r1

r2b

IS2

Depreciation causesthe IS curve toshift to the right


O

r

Y

LM

BP1

IS1

Y1


IS3

a

Y2

r1

r2b

BP2

IS2

Y3

r3c

Full equilibrium isachieved at point c


O

r

Y

LM1

IS1

Y1


a

Y2

r1

r2

BP1

LM2

b


O

r

Y

LM1

IS1

Y1


a

Y2

r1

r2 b

The balance of paymentsdeficit causes the BP line

to shift downward

BP1

LM2


O

r

Y

LM1

IS1

Y1


a

Y2

r1

r2 b

The depreciationcauses the IS curveto shift to the right

BP1

LM2


O

r

Y

BP2

LM1

IS1

Y1


a

Y2

r1

r2 b Full equilibrium isrestored at point c

BP1

IS2

Y3

r3

LM2

c

Fixed exchange rates: The BP curve

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