Skip to content
Sem 5 Prep
← Open Economy MacroThe Mundell-Fleming model with fixed exchange rates

Formulas for this chapter

The three curves

IS goods market negative slope LM money market positive slope BP external balance positive slope Left of BP: surplus. Right of BP: deficit. Devaluation shifts BP down; revaluation shifts it up.

Every diagram question in this chapter and the next. Write the slopes down before you draw anything.

i
The interest rate, on the vertical axis
Y
National income, on the horizontal axis
shifters
IS: fiscal policy, exports, devaluation. LM: monetary policy. BP: the exchange rate

Reading a deficit off the diagram

deficit = (actual income - income at external balance) x MPM Class case: (1,000 - 700) x 0.15 = 45

Whenever the diagram shows the economy to the right of BP and the question asks how big the imbalance is.

income at external balance
The income on BP at the current interest rate. Class case 700 at i = 5.0 %
MPM
The marginal propensity to import, which converts excess income into excess imports

Slope of BP, and the interest rate external balance needs

slope of BP = MPM / capital-flow responsiveness rate rise needed = financing gap / responsiveness financing gap = starting deficit + MPM x change in income

Sizing the monetary leg of any fixed-rate prescription. Net the starting external position before dividing.

responsiveness
Net capital inflow per percentage point of interest rate. High means a flat BP and easy money; low means a steep BP and tight money
financing gap
The total inflow external balance requires after the fiscal expansion

Fixed rate prescriptions by capital mobility

Inelastic (BP steep, left of LM at YF): expansionary fiscal + TIGHT money Elastic (BP flat, right of LM at YF): expansionary fiscal + EASY money Perfect (BP horizontal): expansionary fiscal, monetary INEFFECTIVE

Any question that names a level of capital mobility. The fiscal leg never changes; only the monetary leg does.

class numbers
Inelastic reaches F at i = 8 %, elastic at i = 6.0 %, perfect back at the world rate of 5 %
the deciding test
Steepness and position of BP relative to LM at full-employment income
Step 1 of 28
The ideaTheory

Three dials, one dashboard

Imagine a machine with three warning lights: goods, money, and payments abroad. Each goes green only at certain combinations of two dials, the interest rate and national income.

Draw the green combinations for each light as a line on a graph. Where all three lines cross, all three lights are green.

That graph is the IS-LM-BP diagram, and this chapter is about steering to the crossing point using two levers, fiscal policy and monetary policy, without touching the exchange rate at all.

← BackContinue →