IS-LM-BP Model Flashcards
(18 cards)
What does the BP curve represent?
The BP (Balance of Payments) curve shows combinations of interest rates and income that result in a balanced external account (i.e., BoP = 0)
What are the three markets in the IS-LM-BP model?
Goods market (IS), money market (LM), and foreign exchange market (BP).
What key assumption is made in the Mundell-Fleming model?
Perfect capital mobility — capital can move freely across borders
What’s the difference between fixed and flexible exchange rates?
Fixed rates are pegged and maintained via intervention; flexible rates are determined by market forces.
What causes a balance of payments surplus or deficit in this model?
the level of capital inflows is more than sufficient to offset the deficit in the Current Account that prevails at B
Under flexible exchange rates, which policy is effective?
Monetary policy is effective; fiscal policy is ineffective (crowding out via exchange rate appreciation)
What is the shape of the BP curve under perfect capital mobility?
Horizontal — only the world interest rate 𝑖𝑓 ensures BoP equilibrium at any income level.
Under fixed exchange rates, which policy is effective?
Fiscal policy is effective; monetary policy is ineffective (CB must neutralize monetary effects to maintain fixed rate)
Why is fiscal policy ineffective under flexible exchange rates?
Higher interest rates attract capital inflows → currency appreciates → net exports fall → initial output gains are offset
Why is monetary policy ineffective under fixed exchange rates?
CB must reverse money supply changes to defend the peg, neutralizing policy effects
Why is fiscal policy effective under fixed exchange rates?
Because capital inflows caused by rising interest rates (from fiscal expansion) force the central bank to increase the money supply (buying foreign currency), reinforcing the fiscal stimulus. Output and income rise.
Why is monetary policy effective under flexible exchange rates?
Lower interest rates lead to capital outflows and currency depreciation. This boosts exports (net exports rise), shifting the IS curve right and increasing output and income.
Why is fiscal policy ineffective under flexible exchange rates?
Fiscal expansion raises interest rates, leading to capital inflows and currency appreciation. Exports fall, which offsets the original increase in demand—this is known as exchange rate crowding out.
What shape is the BP curve under perfect capital mobility?
Horizontal at the world interest rate
𝑖𝑓 because even small deviations cause infinite capital flows.
What happens if the domestic interest rate (i_d) is higher than the foreign interest rate (i_f) under perfect capital mobility?
Capital inflows occur → Balance of Payments surplus.
What happens if Id < If?
Capital outflows occur → Balance of Payments deficit.
