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IS - LM - BP Analysis (an example of fixed exchange rates)

Consider the following graphs, which are just like the ones in our chapter 18. In both graphs we have an initial move
from point 1 to 2, representing a contractionary fiscal policy -- say, a rise in tax rates, or a decrease in government
expenditure.

In the first graph, this contractionary policy results in a Balance of Payments (BP) surplus, because the rise in the
Current Account (from lower income) is greater than the fall in the Kapital Account (from a lower interest rate). Hence
there would be a tendency for the currency to appreciate. If the exchange rate is fixed, this will simply mean net capital
inflows and an expansion of the LM curve, expanding national income from 2 to 3. Hence the original aim of the fiscal
policy is counteracted by the monetary response. In the second graph, the fiscal contraction from 1 to 2 moves us into a
Balance of Payments deficit, the KA fall from lower interest rates dominates the rise in the CA from lower income, and
this would cause net capital outflows, or a tendency for the currency to depreciate. This means just a fall in the LM'
curve if the exchange rate is fixed, thus reinforcing the original fiscal contraction by further monetary tightening.

The above is an illustration of the idea (explained in chapter 18) that fiscal policy is more powerful than monetary
under fixed exchange rates and relatively unimpeded foreign capital flows. This can also be seen in terms of which
account is stronger the CA (Current Account) or the KA (Kapital Account). A stronger Kapital Account in the
balance of payments effect tends to make domestic monetary policy passive. This is explained below

The only important difference in the two graphs is that

 in the left-hand graph, international capital markets are less sensitive than domestic capital to changes in i (so the
BP line is steeper than the LM curve), while
 in the right-hand graph, international capital markets are more sensitive than domestic capital to changes in i (so
the BP line is flatter than the LM).

This works out as follows:

(a) The fiscal tightening means a move in the IS curve (shift to the left) in either graph. Also in either graph, this will
lead to an improvement in the CA (because income is falling) and a fall in the KA (because interest rate is lower).
Which of these effects is stronger depends on the relative slopes of the BP and LM curves.

(b) In the graph on the left, we are in surplus. If the BP curve is not to rise (i.e., the currency is not to appreciate),
then there must be an expansion of money supply (shift LM to the right) to offset the fact that the rise in CA is greater
than the fall in KA, with the consequent tendency for the currency to appreciate. So the interest rate must be driven
lower, to drive the KA lower and keep the exchange rate constant.

(c) In the graph on the right, we are in a BP deficit. If the BP is not to fall (i.e., the currency is not to depreciate),
there must be a contraction of the money supply (shift LM to the left) to offset the rise in CA being smaller than the fall
in KA, with the consequent tendency for the currency to depreciate. So the interest rate must be driven higher, to bring
the interest rate back up, thus bolstering the KA to keep the exchange rate constant.

Updated: 2001-10-04, 15:29