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