Open Economy Macroeconomics -- Key Aspects of IS-LM-BOP
The IS-LM model is a theory of how interest rates and GDP are simultaneously determined in an economy like ours. The IS curve is downsloping, like a demand curve, because at a lower interest rate there will be more investment spending, thus higher aggregate expenditure, and thus greater GDP or income (Y). The IS curve is made up of a large number of equilibrium positions, each "dot" representing the Y which results if the interest rate is at that particular level. To construct an actual IS curve would require a lot of investigation. The LM curve is upsloping. It reflects the fact that if Y is greater, that would imply a higher interest rate. Higher GDP causes a higher "demand for money", and, given a supply of money set by the Fed, a higher interest rate. Similarly to what is said above, the LM curve is made up of many "money market" equilibria -- one interest rate which corresponds to each income level.
The two curves intersect at some point. The unique interest rate and Y would cause both the goods market and the money market to be in equilibrium at once. Forces will push the economy to this point. So, given the position of the IS curve, and the position of the LM curve, the i and the income level are determined. If the IS curve shifts to the right (say, due to increased government spending) a new combined equilibrium will result, where i is higher and Y is higher. If the LM curve shifts to the right (say due to an increase in the money supply by the Fed) i will be lower and Y will be higher.
Now add the BOP curve.
This curve may be horizontal (small country) or gently upsloping (large). In the
Considering all this there is a need for a 3-way intersection to have an overall equilibrium (other wise the existing i and Y would not last -- it wouldn't "all balance out".
In a country with fixed exchange rates, starting from a position of overall equilibrium, say the government increases government spending as a stimulative fiscal policy measure -- they want to raise GDP. IS shifts to the right, the new IS-LM intersection involves higher interest rates, but this does not permit BOP equilibrium. The interest rate is too high, and capital inflow will cause appreciation of the exch. rate. The government must respond with a rightward shift of LM (a money supply increase) to keep the exchange rate steady. The LM shift will occur one way or the other -- either by a conscious money supply inccrease, or just because the dollar must be "held down" by having the government sell dollars in currency markets (increasing M). The policy of stimulation succeeds.
But if a stimulative monetary policy approach is considered, it doesn't work well. The LM is shifted right, the interest rate is now too low for BOP equilibrium. Capital outflow will threaten a depreciation of the exchange rate. The interest rate will have to be raised (or actually will automatically rise again) via a left shift of LM. The policy fails. (Why not, at the same time, shift the IS curve to the right to offset the problem? ans.: that's ok, but we have stimulated the economy by a fiscal measure, the monetary measure has still failed.
If the country has flexible exchange rates, the tables are turned. Now fiscal policy doesn't work, but monetary policy works well. Here's why in a nut shell. Fiscal policy stimulation raises interest rates and causes an inflow of foreign capital to take advantage of the rates. The capital inflow means added desire to convert foreign currencies to dollars, which causes an appreciation of the exchange rate. That in turn causes exports to fall and imports to rise -- this is a decrease in net exports, which shifts the IS curve to the left, cancelling the whole thing out. (Remember that the IS curve embodies C+I+G+NX). etc. etc.
These conclusions appear to be very realistic. The 1960s, when exchange rates were fixed, were the hay-day of fiscal policy. Policy actions seemed very successful. Monetary policy was argued to be of little impact. This theory explains why. On the other hand, the fiscal stimulation of the 1980s and beyond, and again in the 2000s, may have had little impact (considering its large dollar amount). Perhaps this is no surprise in view of the fact that the world had switched to flexible exchange rates. If stimulative measures had worked like in the 1960s we would now have roaring inflation due to over stimulation of the economy. Moreover, monetary policy is presently highly regarded and seems to work well when it is used (like in the 1987 stock market crisis, and in the post 9/11 period). The theory supports this experience as well.