CEMSEFB

THE EFFECTIVENESS OF EMP & EFP: IS-LM-BP ANALYSIS

A. FIXED EXCHANGE RATE & IMPERFECT CAPITAL MOBILITY

1. Expansionary Monetary Policy

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EMP→↑MS→LM shifts to the R
(from LM0 to LM1)→New equilibrium occurs below BP curve at point E 1: r = r1 & Y = Y1
(r↓& Y↑).

↓r → capital outflow ↑ 1. BOP deficit ER↑

↑Y→ import↑ 2. DD$↑

Under fixed ER system, the government must maintain the ER level. To maintain the
official ER level, the government will SELL $→MS↓→MS curve shifts back to the LEFT
(from LM1 to LM0)→ Final equilibrium occurs at point E 0: r = r0 & Y = Y0 (r & Y are
unchanged).
EMP is INEFFECTIVE. (see Figure 1)
r
LM0
LM1
BP0
E0
r0 • E1
r1 •
IS
Y
Y0 Y1

Figure 1: Monetary Policy Under Fixed ER System and Imperfect Capital Mobility

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2. Expansionary Fiscal Policy

i. BP curve is flatter than LM curve (capital flows are more responsive to changes in r)

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→ →New equilibrium occurs above BP curve at point E 1: r = r1 & Y =
Y1 (r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 1. BOP surplus ER↓

↑Y→ import↑ MORE responsive to 2. SS$↑ & DDRM↑
changes in r,
↑capital inflow > ↑ import

Under fixed ER system, the government must maintain the ER level. To maintain the
official ER level, the government will BUY $→MS↑→MS curve shifts to the RIGHT
(from LM0 to LM1)→ Final equilibrium occurs at point E 2: r = r2 & Y = Y2 (r↓ (from r1
to r2) & Y↑(from Y1 to Y2).
EFP is MORE INEFFECTIVE. (see Figure 2)

r
LM0
LM1
E1
r1
r2
•E 2
BP
E0 •
r0 •
IS1
IS0
Y
Y0 Y1 Y2

Figure 2: Fiscal Policy Under Fixed ER System and Imperfect Capital Mobility
When Capital Flows are More Responsive to Changes in the Interest
Rate

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ii. BP curve is steeper than LM curve (capital flows are less responsive to changes in r)

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→ →New equilibrium occurs below BP curve at point E 1: r = r1 & Y =
Y1 (r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 1. BOP deficit ER↑

↑Y→ import↑ LESS responsive to 2. DD$↑
changes in r,
↑capital inflow < ↑ import

Under fixed ER system, the government must maintain the ER level. To maintain the
official ER level, the government will SELL $→MS↓→MS curve shifts to the L (from
LM0 to LM1)→ Final equilibrium occurs at point E 2: r = r2 & Y = Y2 (r↑ (from r1 to r2)&
Y↓ (from Y1 to Y2).
EFP is LESS EFFECTIVE (see Figure 3)

r
BP0
LM1
E2
r2
r1
• E1
LM0
E0 •
r0 •
IS1
IS0
Y
Y0 Y2 Y1

Figure 3: Fiscal Policy Under Fixed ER System and Imperfect Capital Mobility
When Capital Flows are Less Responsive to Changes in the Interest
Rate

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B. FLEXIBLE/FLOATING EXCHANGE RATE & IMPERFECT CAPITAL MOBILITY

1. Expansionary Monetary Policy

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EMP→↑MS→LM shifts to the RIGHT
(from LM0 to LM1)→New equilibrium occurs below BP curve at point E 1: r = r1 & Y = Y1
(r↓& Y↑).

↓r → capital outflow ↑ 1. BOP deficit ER↑ 1. PX↓ 1. X↑

↑Y→ import ↑ 2. DD$↑ 2. PM↑ 2. M↓

Under flexible/floating ER system, the ER level is determined by the market and not
controlled by the government. ↑X & ↓M→IS & BP curves shift to the RIGHT (from IS0 to
IS1 & from BP0 to BP1)→ Final equilibrium occurs at point E2: r = r2 & Y = Y2 (r↑ from r1 to
r2 & Y↑ from Y1 to Y2).
EMP is MORE EFFECTIVE (see Figure 4)
r
LM0
LM1
BP0

E0 BP1
r0
r2 • E2
•
r1 •E 1
IS1
IS0
Y
Y0 Y1 Y2

Figure 4: Monetary Policy Under Flexible/Floating ER System and Imperfect

Capital Mobility

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2. Expansionary Fiscal Policy

i. BP curve is flatter than LM curve (capital flows are more responsive to changes in r)

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→ →New equilibrium occurs above BP curve at point E 1: r = r1 & Y =
Y1 (r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 3. BOP surplus

↑Y→ import↑ MORE responsive to 4. SS$↑ & DDRM↑
changes in r,
↑capital inflow > ↑ import

ER↓

1. PX↑
2. PM↓

1. X↓
2. M↑

Under flexible/floating ER system, the ER level is determined by the market and not
controlled by the government. ↓X & ↑M→IS & BP curves shift to the L (from IS 1 to IS2
& from BP0 to BP1)→ Final equilibrium occurs at point E 2: r = r2 & Y = Y2 (r↓ from r1 to
r2 & Y↓ from Y1 to Y2).
EFP is LESS EFFECTIVE (see Figure 5)

r
LM0
E1
BP1
r1 • BP0
E2
r2
•
r0 E0 •
IS1

IS0
Y
Y0 Y2 Y1

Figure 5: Fiscal Policy Under Flexible/Floating ER System and Imperfect Capital

Mobility When Capital Flows are More Responsive to Changes in the
Interest Rate

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ii. BP curve is steeper than LM curve(capital flows are less responsive to changes in r)

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→New equilibrium occurs below BP curve at point E1: r = r1 & Y = Y1
(r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 1. BOP deficit

↑Y→ import↑ LESS responsive to 2. DD$↑
changes in r,
↑capital inflow < ↑ import

ER↑

3. PX↓
4. PM↑

1. X↑
2. M↓

Under flexible/floating ER system, the ER level is determined by the market and not
controlled by the government. ↑X & M↓→IS & BP curves shift to the RIGHT (from IS1 to
IS2 & from BP0 to BP1)→ Final equilibrium occurs at point E2: r = r2 & Y = Y2 (r↑ from r1 to
r2 & Y↑ from Y1 to Y2).
EFP is MORE EFFECTIVE (see Figure 6)

r BP0
BP1
LM0
r2 • E2
r1
E0 E
• 1

r0 • IS2
IS1

IS0
Y
Y0 Y1 Y2

Figure 6: Fiscal Policy Under Flexible/Floating ER System and Imperfect Capital

Mobility When Capital Flows are Less Responsive to Changes in the
Interest Rate

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C. FIXED EXCHANGE RATE & PERFECT CAPITAL MOBILITY

1. Expansionary Monetary Policy

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EMP→↑MS→LM shifts to the RIGHT
(from LM0 to LM1)→New equilibrium occurs below BP curve at point E 1: r = r1 & Y = Y1
(r↓& Y↑).

↓r → capital outflow ↑ 1. BOP deficit ER↑

↑Y→ import↑ 2. DD$↑

Under fixed ER system, the government must maintain the ER level. To maintain the
official ER level, the government will SELL $→MS↓→MS curve shifts back to the LEFT
(from LM1 to LM0)→ Final equilibrium occurs at point E 0: r = r0 & Y = Y0 (r & Y are
unchanged).
EMP is INEFFECTIVE (see Figure 7)

r
LM0
LM1

E0
r0 • E1 BP0
r1 •
IS
Y
Y0 Y1

Figure 7: Monetary Policy Under Fixed ER System and Perfect Capital Mobility

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2. Expansionary Fiscal Policy

Initial equilibrium occurs at point E 0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→New equilibrium occurs above BP curve at point E 1: r = r1 & Y = Y1
(r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 5. BOP surplus

↑Y→ import↑ MORE responsive to 6. SS$↑ & DDRM↑
changes in r,
↑capital inflow > ↑ import

ER↓

Under fixed ER system, the government must maintain the ER level. To maintain the
official ER level, the government will BUY $→MS↑→MS curve shifts to the RIGHT (from
LM0 to LM1)→ Final equilibrium occurs at point E0: r = r0 & Y = Y2 (r unchanged & Y↑
from Y1 to Y2).
EMP is MORE EFFECTIVE (see Figure 8)

r
LM0
LM1
E1
r1 •
E0 E2
r0 • • BP0
IS1
IS0
Y
Y0 Y1 Y2

Figure 8: Fiscal Policy Under Fixed ER System and Perfect Capital Mobility

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D. FLEXIBLE/FLOATING EXCHANGE RATE & PERFECT CAPITAL MOBILITY

1. Expansionary Monetary Policy

Initial equilibrium occurs at point E0: r = r0 & Y = Y0. EMP→↑MS→LM shifts to the RIGHT
(from LM0 to LM1)→New equilibrium occurs below BP curve at point E 1: r = r1 & Y = Y1
(r↓& Y↑).

↓r → capital outflow ↑ 1. BOP deficit ER↑ 1. PX↓ 1. X↑

↑Y→ import ↑ 2. DD$↑ 2. PM↑ 2. M↓

Under flexible/floating ER system, the ER level is determined by the market and not
control by the government. ↑X & ↓M→IS & BP curves shift to the RIGHT (from IS0 to IS1
& from BP0 to BP1)→ Final equilibrium occurs at point E2: r = r0 & Y = Y2 (r unchanged &
Y↑ from Y1 to Y2).
EMP is MORE EFFECTIVE (see Figure 9)

r
LM0
LM1

E0 E2
r0 • E1 • BP0 = BP1
r1 •
IS1
IS0
Y
Y0 Y1 Y2

Figure 9: Monetary Policy Under Flexible/Floating ER System and Perfect

Capital Mobility

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2. Expansionary Fiscal Policy

Initial equilibrium occurs at point E 0: r = r0 & Y = Y0. EFP→↑G→IS shifts to the RIGHT
(from IS0 to IS1)→ →New equilibrium occurs above BP curve at point E 1: r = r1 & Y =
Y1 (r↑& Y↑).

↑r → capital inflow ↑ Since capital flows are 1. BOP surplus

↑Y→ import↑ MORE responsive to 2. SS$↑ & DDRM↑
changes in r,
↑capital inflow > ↑ import

ER↓

1. PX↑
2. PM↓

X↓
2. M↑

Under flexible/floating ER system, the ER level is determined by the market and not
controlled by the government. ↓X & ↑M→IS & BP curves shift to the LEFT (from IS1 to
IS2 & from BP0 to BP1)→ Final equilibrium occurs at point E 0: r = r0 & Y = Y0 (r & Y
unchanged).
EFP is INEFFECTIVE (see Figure 10)

r
LM0

E1
r1 •
E0
r0 • BP0 = BP1
IS1
IS0
Y
Y0 Y1

Figure 10: Fiscal Policy Under Flexible/Floating ER System and Perfect Capital
Mobility

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