The IS-LM-BP model combines goods, money, and foreign exchange markets to analyze macroeconomic policies in open economies. It shows how fiscal and monetary policies impact output, interest rates, and balance of payments under different exchange rate regimes and capital mobility conditions.

The model highlights the "impossible trinity" concept, where countries can't simultaneously have fixed exchange rates, free capital flows, and independent monetary policy. This framework helps policymakers understand trade-offs and choose optimal strategies for managing their economies in a globalized world.

IS-LM-BP Model and Policy Analysis

Interaction in IS-LM-BP model

• Macroeconomic framework integrates goods market (IS), money market (LM), and balance of payments (BP)
  • IS curve shows equilibrium in goods market where investment equals saving at various interest rates and output levels
  • LM curve shows equilibrium in money market where money supply equals money demand at various interest rates and output levels
  • BP curve shows equilibrium in foreign exchange market where balance of payments is zero at various interest rates and output levels
• Closed economy equilibrium interest rate and output level determined by intersection of IS and LM curves
• Open economy introduces BP curve to capture impact of international capital flows
  • BP curve position depends on exchange rate regime (fixed or floating) and degree of capital mobility (perfect or imperfect)
• Simultaneous equilibrium of goods, money, and foreign exchange markets achieved at intersection of IS, LM, and BP curves (general equilibrium)

Policy effectiveness across exchange regimes

• Fixed exchange rate regime:
  • Fiscal policy effectively influences output and employment
    • Expansionary fiscal policy shifts IS curve right, increasing output and causing balance of payments deficit
    • Central bank maintains fixed exchange rate by selling foreign reserves and buying domestic currency, shifting LM curve left until BP curve restores equilibrium
  • Monetary policy ineffective in influencing output and employment
    • Expansionary monetary policy shifts LM curve right, causing balance of payments surplus and appreciation pressure on domestic currency
    • Central bank maintains fixed exchange rate by buying foreign reserves and selling domestic currency, offsetting initial monetary expansion
• Flexible exchange rate regime:
  • Fiscal policy less effective in influencing output and employment
    • Expansionary fiscal policy shifts IS curve right, appreciating domestic currency
    • Appreciation reduces net exports (trade balance), partially offsetting expansionary effect of fiscal policy
  • Monetary policy effectively influences output and employment
    • Expansionary monetary policy shifts LM curve right, depreciating domestic currency
    • Depreciation increases net exports, reinforcing expansionary effect of monetary policy

Impossible trinity concept and implications

• Impossible trinity (trilemma) states country cannot simultaneously achieve:
  1. Fixed exchange rate
  2. Free capital mobility
  3. Independent monetary policy
• Country must choose two out of three goals, pursuing all three simultaneously inconsistent and unsustainable
• Policy implications of impossible trinity:
  • Maintaining fixed exchange rate and free capital mobility requires giving up independent monetary policy
    • Eurozone countries have common currency (euro) and free capital mobility but limited control over monetary policy
  • Maintaining fixed exchange rate and independent monetary policy requires restricting capital mobility
    • China maintained fixed exchange rate and independent monetary policy by imposing capital controls
  • Maintaining free capital mobility and independent monetary policy requires allowing exchange rate to float freely
    • United States has flexible exchange rate, free capital mobility, and independent monetary policy (Federal Reserve)

Capital mobility in IS-LM-BP model

• Capital mobility refers to ease of financial asset flows across borders in response to interest rate differentials
• Degree of capital mobility affects slope of BP curve
  • Perfect capital mobility: BP curve is horizontal, small changes in interest rates lead to large capital flows
  • Low capital mobility: BP curve is steeper, larger changes in interest rates required to induce capital flows
• Impact of capital mobility on policy outcomes:
  • Perfect capital mobility and fixed exchange rate regime:
    • Fiscal policy highly effective, horizontal BP curve allows large increase in output without causing balance of payments disequilibrium
    • Monetary policy completely ineffective, changes in money supply offset by capital flows to maintain fixed exchange rate
  • Perfect capital mobility and flexible exchange rate regime:
    • Fiscal policy less effective, appreciation of domestic currency following fiscal expansion reduces net exports, partially offsetting expansionary effect
    • Monetary policy highly effective, depreciation of domestic currency following monetary expansion increases net exports, reinforcing expansionary effect
  • Low capital mobility:
    • Effectiveness of fiscal and monetary policies lies between extreme cases of perfect capital mobility and no capital mobility
    • Steeper BP curve allows some degree of policy autonomy, larger changes in interest rates required to induce capital flows and restore balance of payments equilibrium