1. International Money & Finance Chapter 13: The IS-LM-BP Approach
Michael Melvin and Stefan Norrbin

2. Outline of This Chapter
Macroeconomic Equilibrium: three markets
Building the IS curve
Building the LM curve
Building the BP curve
The IS-LM-BP model
Policy Analysis: fiscal vs. monetary
Under fixed exchange rates,
Under floating exchange rates,
International Policy Coordination

3. Economic Goals of an Open Economy
To reach internal balance and external balance.
Internal balance – a steady growth of the economy (low unemployment rate, markets are in equilibrium, resources are efficiently used).
External balance – achieve a desired trade balance or desired international capital flows.

4. Three equilibrium conditions
Goods market equilibrium
The quantity of goods and services supplied is equal to the quantity demanded.
This is the IS curve
Money market equilibrium
The willingness to hold money is equal to the quantity of money supply.
This is the LM curve.
Balance of payments equilibrium
The current account deficit is equal to the capital account surplus, so that the official settlements equals to zero.
This is the BP curve.

5. Equilibrium in three markets
Good market (IS)
Money market (LM)
Balance of payments (BP)
When three curves cross at the same point, the equilibrium interest rate i* clears all three markets simultaneously.

6. Deriving the IS curve Income leakages = domestic spending injections
S + T + IM = I + G + X (1)
S = domestic saving
T = taxes
IM = imports
I = investment spending (ex. new plants)
G = government spending
X = exports
When the leakages equal to the injections, then the value of income received from producing goods and services will equal to total spending.

7. Deriving the IS curve We assume: S depends on income
Higher income, people tend to save more.
T is arbitrarily set by the government.
IM depends on income
Higher income, people buy more goods and imported goods.
I depends on interest rate
Higher interest rate, higher the costs of borrowing and hence decrease the willingness to invest.
G is arbitrarily set by the government.
X depends on foreign income
If people in trading partner countries are wealthier, they will buy more from us.

8. IS Curve
IS curve – the various combinations of i and Y that satisfy the equality in the equation (1).
Every point on the IS curve represents an equilibrium in the goods market.
IS curve is downward sloping
If interest rate falls, investment projects become more profitable. So, investment increases. More investment spending will create more production and generate more income. Thus, income rises.
↓ i → ↑Y
↑ i → ↓ Y

9. The IS Curve

10. Deriving the LM curve 𝑴 𝑺 = 𝑴 𝒅 (𝒊, 𝒀) Money supply = Money demand
MS money supply is fixed (by the Fed)
The money supply curve is vertical.
Md money demand is a function of income (Y) and interest rate (i).
Higher income: people will hold more cash as the amount of transactions increases with their income.
Positive relationship
Higher interest rate: the opportunity cost of holding cash increases, people are less likely to hold cash than before.
Inverse relationship

11. Deriving the LM curve Money supply is a vertical curve
The central bank controls the amount of money in the circulation.
Money demand is a downward-sloping curve.
An increase in interest rate decreases the quantity demanded for money.
An increase in income will shift the entire demand for money curve to the right.
Suppose that the market is initially in an equilibrium, an increase in income will increase the demand for money. But, since the amount of money supplied is fixed, it would cause an excess demand for money at the same interest rate. Thus, interest rate must rise to discourage cash holding and bring the market to a new equilibrium

12. The LM Curve
LM curve – the combinations of i and Y that bring the money market into equilibrium.
Ever point on the LM curve bring the demand for money to equal to the supply of money.
LM curve is upward sloping curve.

13. The BP Curve
BP curve – the combinations of I and Y that yield balance of payments equilibrium.
The BOP equilibrium occurs when:
The current account surplus = the capital account deficit
CS = CD
So, the official settlement = 0

14. The BP Curve

15. The BP curve
Higher interest rate at home attracts foreign investors → current account is able to sustain higher deficit.
Different shapes of the BP curve:
If capital is perfectly mobile, the BP curve is horizontal.
If capital is not perfectly mobile, then the BP curve is upward sloping.
If the capital is perfectly immobile (due to restrictions), then the BP curve is vertical.

16. Shifting the curves Curves Variables that shift the curve IS
Domestic price, exchange rate, government spending, and taxes LM
A change in money supply BP
A change in perception of asset substitutability
(ex. a change in riskiness of a country’s assets)

17. Two Policy Types
Policy aims to promote the full-employment production and stable price levels.
Fiscal Policy: G and T
When G > T, the government runs budget deficit.
This is also called “expansionary fiscal policy.”
When G < T, the government runs budget surplus.
This is “restrictive fiscal policy.”
Fiscal policy will shift the IS curve
Monetary Policy: Ms
Increase money supply = expansionary monetary policy
Decrease money supply = restrictive monetary policy
Monetary policy will shift the LM curve

18. Monetary Policy under Fixed Exchange Rates
Assume perfect capital mobility
Suppose the central bank increases the money supply.
LM shifts to the right.
At e’, the good market and the money market are in equilibrium.
Interest rate falls and income rises.
Large capital outflow
Large official settlements deficit
Pressure the domestic currency to depreciate.
To peg, the central bank has to buy domestic currency and sell foreign currency.
Buying domestic currency will decrease the money supply.
Move the LM back to its original location.
Monetary policy is ineffective under fixed exchange rates.

19. Fiscal Policy under Fixed Exchange Rates
Assume a perfect capital mobility.
Suppose that government uses an expansionary fiscal policy.
IS curve shifts to the right.
Income rises and interest rate rises (at e’)
Large capital account surplus (because of higher i)
Official settlements become a surplus.
Pressure the domestic currency to appreciate.
To peg, the central bank has to buy foreign currency and sell domestic currency.
Increase the money supply.
LM shifts to the right.
Fiscal policy increases income in a country with a fixed exchange rate.

20. Monetary Policy under Floating Exchange Rate
Assume perfect capital mobility.
Suppose the central bank increases money supply.
LM shifts to the right.
Income rises and interest rate falls (at e’).
Large current account deficit
Official settlements deficit
Domestic currency depreciates.
Currency depreciation makes domestic exports become relatively cheaper.
An increase in exports shifts the IS curve to the right.
New equilibrium (e”): income rises and i = iF.
Monetary policy increases the domestic income under floating exchange rates.

21. Fiscal Policy under Floating Exchange Rates
Assume a perfect capital mobility.
Suppose that the government uses an expansionary fiscal policy.
IS curve shifts to the right.
Income rises and interest rate rises (at e’).
Capital account surplus (because domestic i > iF).
Official settlements surplus
The domestic currency appreciates.
An appreciation of the domestic currency shifts the IS curve to the left.
Return to the original equilibrium point.
With floating exchange rates, fiscal policy is ineffective.

22. Applying the IS-LM-BP model: Asian Financial Crisis, Part I
In 1997, investors perceived that assets in Thailand were riskier than other countries.
To defend the fixed exchange rate, the Bank of Thailand had to buy Thai baht and sell dollar reserves.
This would reduce the money supply, shifting LM to the left.
Domestic interest rate rose sharply → discourage investment → income falls
Thailand went into a deep recession

23. Applying the IS-LM-BP model: Asian Financial Crisis, Part II
In July 1997, Thai government decided to allow the exchange rate to float.
The sharp depreciation of Thai baht improved the country’s competitiveness in exporting goods.
The IS curve shifts to the right.
The recovery began. Income and employment started to rise.

24. International Policy Coordination
Motivation: with high degree of capital mobility, fiscal policy in each country could cause divergence of interest rates, and thus lead to exchange rate adjustments. If all countries can synchronize their fiscal actions, it could minimize such exchange rate volatility.
Benefits: stable exchange rates, stable trade, no sharp movements of capital flows, and crisis deterrence.
This topic is still widely debated.
It is not an easy task to design a set of “rules of the game” within which countries can pursue their own national objectives and yet which still leads to some form of global coordination of macroeconomic policies.

25. Conclusions
The desired economic outcome in an open economy is to achieve both internal balance and external balance at the same time.
Internal balance refers to a domestic equilibrium condition such that good market and money market are in equilibrium and unemployment is at its natural level.
External balance requires the balance of payments to be in equilibrium. The condition implies zero balance on the official settlement – the current account surplus must be equal to the capital account deficit.
The IS curve represents the combinations of income and interest rate levels that bring the good market to equilibrium (i.e. leakages equals to injections).
The LM curve represents the combinations of income and interest rate levels that bring the money market to equilibrium (i.e. money demand equals to money supply).
The BP curve represents the combinations of income and interest rate levels that bring the balance of payments to equilibrium (i.e. current account surplus equals to capital account deficit).
The internal and external equilibriums occur when three curves intersect at one point.

26. Conclusions
The factors that shift the IS curve are a change in domestic price level, a change in exchange rate, and a change in fiscal policy variable.
The factor that shifts the LM curve is a change in money supply.
The factor that shifts the BP curve is a change in perception of asset substitutability.
With perfect substitutability and perfect capital mobility, the domestic interest rate is equal to the foreign interest rate.
With fixed exchange rates, a country cannot conduct an independent monetary policy to change domestic income. Only fiscal policy is effective in changing equilibrium income.
With floating exchange rates, monetary policy is effective in changing domestic income. However, fiscal policy has no effect on income because of a complete crowding-out effect from the balance of payments adjustment.
International policy coordination is an idea that aims to stabilize the exchange rates by coordinating each country’s fiscal and monetary policies to achieve the best international outcome.