The IS-LM-BP model is an extension of the IS-LM model that analyses the relationship between the interest rate and GDP, where the IS curve is the goods market; the LM curve is the money market. Firstly the IS curve is in equilibrium condition when the production for goods is equal to the demand for goods. The LM curve is in equilibrium when the demand for money is equal to the supply of money. Since in the short run the money supply cannot be increased or decreased therefore the interest rate will change to compensate the change in demand. This is a closed economy model; however with the inclusion of the BP curve an open economy model is created.
When comparing the effectiveness of the monetary policy under the different exchange rates, the slope of the BP curve in the model has to be taken under consideration. The responsiveness of capital flows will affect the slope of the BP curve. Firstly when the capital is perfectly mobile the BP curve is horizontal, and when capital is perfectly immobile, no capital is allowed into or out of the country, meaning an increase in the interest rates will have no effect on capital flows and the balance of payments.
Above the BP curve the balance of payments is in surplus and below the BP curve, the balance of payments is in deficit. The slope will be flatter if the marginal propensity to import is smaller, this means an increase inn income leads to a small increase in imports; so only a small increase in interest rates is needed for BoP equilibrium. If the country is small as the required capital inflow to offset the current account deficit is very small relative to world supplies of capital. When capital is internationally mobile, the required capital inflow to offset the current account deficit needs only a small increase in interest rates as capital moves very quickly to where the rate of return is highest.
Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rates. In the IS-LM-BP model the interest rate is what is used to control change the balance of payments. This will be explained throughout the essay how the change in interest rates affect the model under fixed and flexible exchange rates.
Firstly we will look at monetary policy under a fixed exchange rate and how the is affected by the capital mobility being perfect. Fixed exchange rates are when a country fixes their exchange rate to a certain value i.e. the UK government pegging the British pound to the euro. An expansionary monetary policy will shift the LM curve to LM1, which makes the equilibrium go to E0 to E1. This pushes the balance of payments into a deficit as the equilibrium is below the BP curve. Since the exchange rates are fixed, the government will have to intervene by buying domestic currency and selling foreign currency to reduce the money supply, shifting the LM curve back to its original position. This put the model back in equilibrium at E2 where the original equilibrium showing that monetary policy has no effect under a fixed exchange rate when the capital is perfectly mobile.
When the government intervenes, the change from the initial shift from LM to LM1 this occurs more or less straight away however the shift back to the original position doesn’t take place straight away time lags occur as the change take time to go back to equilibrium.
Under a flexible exchange rate monetary policy has more of an affect within this model. A flexible exchange rate is when the exchange rate it left to the forces of supply and demand to determine the rate. The same expansionary policy that has been applied above would yet again shift the LM curve to LM1, which makes the equilibrium go from point E0 to E1. However, since the exchange rates are flexible, the balance of…