Question

Explain in detail the policy conclusions of the IS/LM/BP model

Answer 1

ISLMBP model is also known as mundell Fleming model. IS curve represents goods market equilibrium and LM curve represents money market equilibrium and BP curve represents Balance of payment equilibrium.It is an extension of ISLM model in an open economy.

ISLMBP model explain with the policy implications. This can be explained with the help of following diagrams.

Under Fixed exchange rate system

If an expansionary monetary policy under fixed exchange rate system shifts the LM curve to the right. Which is below the BOP (balance of payment deficit). In order to overcome the problem and maintain initial equilibrium, government purchase domestic currencies. As a result LM shifts back to the normal position . Monetary policy has no effect under fixed exchange rate system. An expansionary fiscal policy shifts IS to the right.new equilibrium point is established at E2.there is BOP surplus in the economy. Here government intervention is essential. So government purchase foreign currencies and sell domestic currency. So that money supply increases and the LM curve shifts to the right. And with the same interest rate new equilibrium point is established. Fiscal policy is effective under fixed exchange rate system.

2. Under flexible exchange rate system

If expansionary monetary policy is introduced, the LM curve shifts to the right and new equilibrium point is established. Now country has BOP deficit that depreciate domestic currency.which means foreigners now can purchase more quantities than before. As a result IS shifts to the right and at the same rate of interest new equilibrium point is established.here monetary policy is highly effective. If expansionary fiscal policy introduced in the economy, IS curve shifts to the right. New equilibrium point is established. Now country has BOP surplus. But they domestic country's currency appreciates. So net imports of foreigners come down as a result IS shifts back to its original position (IS to IS1)