IS-LM-BP Diagram

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Fiscal Stimulus
Fixed
Flexible
 
Monetary Stimulus
Fixed
Flexible
Devaluation
 
Capital Inflow
Fixed
Flexible

Key:

Y National income and output E Exchange rate (domestic currency price of foreign currency)
i Interest rate (real=nominal since prices are constant) K Exogenous capital inflow
IS Goods market equilibrium (investment=savings) G Government spending
LM Money market equilibrium (demand for money, L, equals supply) M Money supply
BP Balance of payments (BOP) curve

Explanation:

Equilibrium is at the intersection if IS and LM. With a pegged exchange rate this may lie off the BP curve, indicating a BOP in surplus (+) above or deficit (-) below. With a floating exchange rate, a secondary adjustment of the exchange rate, E, (with effects shown in green) must move the three curves so as to intersect in one place, in order to get equilibrium in the exchange market.

From the diagram, one can read the following effects of exogenous changes, for the case shown (which assumes relatively mobile capital and sterilization of exchange market intervention -- see notes below):

Fiscal expansion
An increase in government spending (or a tax cut) shifts the IS-curve to the right. With a fixed exchange rate this causes income and the interest rate both to rise. The rise in interest rate attracts a capital inflow that, with relatively mobile capital, is sufficient to create a BOP surplus. With a flexible exchange rate this is an excess demand for domestic currency, which therefore appreciates. The appreciation dampens the increase in both income and the interest rate.
Monetary expansion
An increase in the money supply shifts the LM curve to the right, raising income and lowering the interest rate. With a fixed exchange rate, both of these changes contribute to BOP deficit. With a flexible rate, this is an excess supply of domestic currency, which therefore depreciates. The depreciation further stimulates income, but dampens the fall in interest rate.
Devaluation
A devaluation of the otherwise fixed exchange rate stimulates demand for domestic goods shifting the IS-curve to the right, but also shifting the BP curve down and creating a BOP surplus. (This ignores the possibility of a J-curve -- see below.)
Capital Inflow
An exogenous capital inflow has no effect on IS or LM under a fixed exchange rate, since the central bank is sterilizing its effect on the interest rate. It merely causes a BOP surplus. With a flexible rate, however, this surplus causes an appreciation, which reduces demand and shifts the IS-curve to the left. Thus the capital inflow lowers income and the interest rate under a flexible exchange rate.

Notes:

  1. The relative slopes of the LM and BP curves are crucial to some of these results. The case shown assumes that capital is sufficiently mobile internationally that the BP curve is flatter than the LM curve. The extreme case of perfect capital mobility would have a horizontal BP curve.

  2. In addition to the two cases shown, one could (and should) also look at the case of a fixed exchange rate with nonsterilization. In that case, whenever there is a BOP disequilibrium the money supply will be changing, rising with a surplus and falling with a deficit (which are in turn indicated by the + and - signs in the diagram). The LM curve therefore shifts until all three curves intersect at once.

  3. Exchange rate devaluation (and depreciation) is shown as shifting the IS and BP curves both to the right. This requires that import demand elasticities are large enough to satisfy the Marshall-Lerner Condition. Without this, as is perhaps likely in the short run, both would shift in the other direction. This is one possible cause of the J-curve, worsening the balance of trade in the short run, and also reducing aggregate demand.

  4. An exogenous change in exports and/or imports due to any of a variety of causes ranging from changing trade policies to business cycle fluctuations abroad will have effects under fixed exchange rates similar to the devaluation shown above. Under a flexible exchange rate, however, matters are complicated by the need to know how an exchange rate change alters capital flows. Depending on the nature of expectations, among other things, anything -- or nothing -- is possible. In particular, it may be that, say, an exogenous increase in exports will be exactly offset, in its effects on the trade balance and aggregate demand, by an exchange rate appreciation.

  5. The model here takes all foreign variables as given, under the assumption that this is a small open economy. If that is not the case, there will be foreign repercussions from the foreign response to this country's changes in trade and capital flows, and results may change.