11The IS-LM-BP ModelAgenda• The Balance of Payments¾ Policy Analysis with Partial Capital Mobility¾ Currency Crises¾ International Capital Flows & Indebtedness2The IS-LM-BP Model• Policy Analysis with the BP Curve¾ The intersection of the IS-LM curves establishes internal equilibrium.¾ The BP curve establishes external equilibrium.¾ If joint internal and external equilibrium does not exist, then either:• The currency must appreciate or depreciate, or• The central bank must intervene to stabilize the currency3Capital Mobility• The slope of the BP line indicates the degree of capital mobility in a country¾ Horizontal: perfect capital mobility• Domestic R = World R¾ Vertical: complete capital immobility• Domestic R completely independent of world R¾ Upward sloping: partial capital mobility• Domestic R differs from the world R4Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy, fixed exchange rates¾ IS curve shifts right, Y and R increase.¾ Higher R increases foreign capital inflow.• Creates BP surplus and upward pressure on currency.¾ Central bank intervenes in the foreign exchange market.• Buys excess foreign currency.¾ Increases foreign exchange reserves.• Sells domestic currency.¾ Increases the domestic money supply. • That is, non-sterilized intervention.¾ LM curve shifts right, Y increases, R decreases to its original level.¾ Result is higher Y and R.5RExpansionary Fiscal Policy,Fixed Exchange RatesYY0R0IS0BP0LM06RExpansionary Fiscal Policy,Fixed Exchange RatesYY0R0IS0BP0LM0IS1R1Y127RExpansionary Fiscal Policy,Fixed Exchange RatesYY0R0IS0BP0LM0IS1R1Y1LM2Y2R28Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy with fixed exchange rates is powerful because it forces monetary policy to be fully accommodating.9Policy Analysis with Partial Capital Mobility• Expansionary monetary policy, fixed exchange rates¾ LM shifts right, Y increases and R decreases¾ Lower R decreases foreign capital outflows • Creates BP deficit and downward pressure on currency.¾ Central bank intervenes in the foreign exchange market.• Sells foreign exchange reserves.• Buys excess domestic currency.¾ Decreases the domestic money supply.• That is, non-sterilized intervention.¾ LM curve shifts left, Y decreases and R increases to its original level.¾ Result is same Y and R.10RExpansionary Fiscal Policy,Fixed Exchange RatesYY0R0IS0BP0LM011RExpansionary Monetary Policy,Fixed Exchange RatesYY0R0IS0BP0LM0LM1R1Y112RExpansionary Monetary Policy,Fixed Exchange RatesYY0 = Y2R0 = R2IS0BP0LM0 = LM2LM1R1Y1313Policy Analysis with Partial Capital Mobility• Expansionary monetary policy with fixed exchange rates is completely ineffective, i.e. there is no independent monetary policy.14Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy, flexible exchange rates¾ IS curve shifts right, Y and R increase¾ Higher R increases foreign capital inflows.• Creates BP surplus and currency appreciates.• Stronger currency reduces net exports.¾ Lower exports, higher imports.• IS curve and BP line shift left.¾ Result is higher Y and R.15RExpansionary Fiscal Policy,Flexible Exchange RatesYY0R0IS0BP0LM016RExpansionary Fiscal Policy,Flexible Exchange RatesYY0R0IS0BP0LM0IS1R1Y117RExpansionary Fiscal Policy,Flexible Exchange RatesYY0 Y2R0IS0 IS2BP0LM0IS1R1Y1BP2R218Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy with flexible exchange rates is partially effective.¾ Exchange rate effects partially offset fiscal policy changes.419Policy Analysis with Partial Capital Mobility• Expansionary monetary policy, flexible exchange rates• LM curve shifts right, Y increases and R decreases.• Lower R reduces foreign capital inflows.• Creates BP deficit and downward pressure on currency.• Currency depreciation stimulates net exports.• Higher exports, lower imports.• IS curve and BP line shift right.• Result is higher Y and lower R.20Expansionary Monetary Policy,Flexible Exchange RatesYY0R0IS0BP0LM0R21RExpansionary Monetary Policy,Flexible Exchange RatesYY0R0IS0BP0LM0LM1R1Y122RExpansionary Monetary Policy,Flexible Exchange RatesYY0R0IS0BP0LM0LM1R1Y1IS2Y2R2BP223Policy Analysis with Partial Capital Mobility• Expansionary monetary policy with flexible exchange rates is very powerful because it forces net exports to be fully accommodating.¾ Exchange rate effects compliment monetary policy adjustment.24Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy, fixed exchange rates, sterilized FX intervention, alternative FX policies¾ IS curve shifts right, Y and R increase.¾ Higher R increases foreign capital inflow.• Creates BP surplus and upward pressure on currency.¾ Central bank intervenes in the foreign exchange market.• Buys excess foreign currency.¾ Increases foreign exchange reserves.• Sells domestic currency and simultaneously buys government securities in open market.¾ Results in no change in the domestic money supply. • That is, sterilized intervention.¾ LM curve shifts does not shift.525Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy, fixed exchange rates, sterilized FX intervention, alternative FX policies¾ Government MUST pursue alternative FX policies to re-establish joint equilibrium.• Restrict (autonomous) exports.¾ Which will also shift the IS curve to the left.• Encourage (autonomous) imports.¾ Which will also shift the IS curve to the left.• Encourage (autonomous) capital outflows.• Restrict (autonomous) capital inflows.¾ These will shift the BP line to the left.26Expansionary fiscal policy, fixed exchange rates, sterilized FX intervention, alternative FX policiesYY0R0IS0BP0LM0R27RExpansionary fiscal policy, fixed exchange rates, sterilized FX intervention, alternative FX policiesYY0R0IS0BP0LM0IS1R1Y128RExpansionary fiscal policy, fixed exchange rates, sterilized FX intervention, alternative FX policiesYY0R0IS0BP0LM0IS1R1 = R2Y1 = Y2BP229Policy Analysis with Partial Capital Mobility• Expansionary fiscal policy with fixed exchange rates and sterilized FX intervention requires using alternative FX policies to re-establish joint equilibrium in the economy.¾ Y is lower and R is higher than with non-sterilized FX intervention.30Currency Crises• Countries that experience currency crises typically have a similar economic environment.¾ Small economies with fixed exchange rates.¾ Large budget