ISLMBP Model

1

• Question 4A Fixed Exchange Rates-Sticky Prices-
  Decrease in Nominal International Rate (20
  points)
• Given
• Decrease in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change

ISLM-BP Model
R
LM1 (M, P)
Summary According to the ISLM-BP model, if an
economy is already at full employment, a drop in
nominal intl rates will cause the domestic
economy to overheat. How? Imagine the domestic
economy is already at equilibrium as follows
RRd
BP
IS1 (C,I,G,CA)
Y Y
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl) d (Risk
Premium)
2

• Question 4A Fixed Exchange Rates-Sticky Prices-
  Decrease in Nominal International Rate (20
  points)
• Given
• Decrease in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change

ISLM-BP Model
R
LM1 (M, P)
Analysis Short-term impact on ISLM model Step 1
If Nom. Intl. Rates go down then Rgt R This
leads to capital inflows which will cause an
appreciation of the local currency. Why? Ee
E (Interest Rate Parity
Condition) 1R- R The central bank will
intervene by buying OIR to depreciate the currency
RRd
BP
R
IS1 (C,I,G,CA)
Assets Liabilities
OIR High-powered money (H)
(also equivalent to a
decrease Domestic credit in money supply
(M)) (I.e. treasury bonds)
Y Y1 Y
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl)

d (Risk Premium)
3

• Question 4A Fixed Exchange Rates-Sticky Prices-
  Decrease in Nominal International Rate (20
  points)
• Given
• Decrease in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change

ISLM-BP Model
R
LM1 (M, P)
LM2 (M )
Analysis Short-term impact on ISLM model Step 2
Since money supply (M) has increased, The LM1
curve shifts out to LM2 and the economy overheats
to Y1. Because the M has increased domestic
rates have decreased to equal the new
intl nominal rate hence you see the new BP2 line.
BP1
RRd
BP2
RRd
IS1 (C,I,G,CA)
In a fixed rate regime under the ISLM-BP model,
a drop in R causes an appreciation which the CB
will offset by depreciating the currency
(reducing M). This will lower domestic rates and
overheat an economy already at full employment.
Y
Y1
Key LM Curve PPrices (Domestic) Note
Price has a negative relationship to LM curve
(I.e. if P increases,LM curve shifts left)
MMoney Supply Note
Money supply has a positive relationship to LM
Curve (I.e. if M increases, LM curve goes right)
IS Curve CConsumption IInvestment (
a function of RRate (domestic), GGovt
Spending, CACurrent Acct All Positive
Relationship to IS Curve BP Curve- R
Rate (Domestic), RRate (Intl)

d (Risk Premium)
4

• Question 4A Fixed Exchange Rates-Sticky Prices-
  Decrease in Nominal International Rate (20
  points)
• Given
• Decrease in Nominal International Rate
• Sticky prices
• Fixed exchange rate
• Permanent change

Summary There is minimal impact in the AA/DD
model if R drops. Initially AA1 curve shifts
back to AA2 This slows the economy to from Y to
Y1 and leads to an appreciation of the currency
to E2 Since the exchange rate is supposed to be
fixed, the central bank intervenes to depreciate
the currency by buying official international
reserves (OIR) with local currency which is like
increasing the money supply.
AA / DD Model
E
DD1 (T,P, G,I, P)
E1
Assets Liabilities
OIR High-powered money (H)
(also equivalent to an
decrease Domestic credit in money supply
(M)) (I.e. treasury bonds)
E2
2 1
2 1
AA2
AA1 (M,E,R, P)
AA2 (R )
Since money supply (M) has increased,The AA2
curve shifts back to AA1 and the economy moves
back to Y. E2 will move back to E1.
Y1 Y Y
1 2
5

• Question 4B Fixed Exchange Rates-Sticky Prices-
  TOBIN TAX
• Given
• TOBIN TAX
• Sticky prices
• Fixed exchange rate
• Permanent change

The Tobin tax has often been discussed as a means
to minimize the impact of capital flows that
can lead to financial crises. For example, much
of the Asian financial crises stemmed from the
unexpected and rapid outflow of hugh amounts of
short-term capital. By taxing the flow of
capital, the Tobin tax should theoretically slow
down capital movement and help governments tailor
the types of capital desired. In reality, such a
tax is not feasible unless the following
conditions are met 1. All countries imposed
such a tax, 2. A clear mechanism existed to
differentiate between short-term versus long-term
capital 3. Penalties were enforceable. .
6

• Question 4B Fixed Exchange Rates-Sticky Prices-
  TOBIN TAX
• Given
• TOBIN TAX
• Sticky prices
• Fixed exchange rate
• Permanent change

Under Construction
Tobin Tax
E1
E2 Ee 1R-R T
E Ee 1R-R
R1 R0R1T
L(R,Y)
M2 P2
M1 P1