IS-LM-BP model - IS-LM-BP model The IS-LM-BP model(also known as IS-LM-BoP or Mundell-Fleming model is an extension of the IS-LM model which was

IS-LM-BP model - IS-LM-BP model The IS-LM-BP model(also...

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IS-LM-BP model The IS-LM-BP model (also known as IS-LM-BoP or Mundell-Fleming model) is an extension of the IS-LM model , which was formulated by the economists Robert Mundell and Marcus Fleming , who made almost simultaneously an analysis of open economies in the 60s. Basically we could say that the Mundell-Fleming model is a version of the IS-LM model for an open economy. In addition to the balance in goods and financial markets, the model incorporates an analysis of the balance of payments . Even though both economists researched about the same topic, at about the same time, both have different analyses. Mundell’s paper “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates”, 1963, analyses the case of perfect mobility of capital , while Fleming´s model, depicted in his article “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, 1962, was more realistic as it assumed imperfect capital mobility, and thus made this one a more rigorous and comprehensive model. However, nowadays, his model has lost cogency, as the actual world situation has more resemblance with total capital mobility, which corresponds better to Mundell’s view. In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Secondly, the LM curve, which represents the equilibrium in the money market. Thirdly, the BP curve, which represents the equilibrium of the balance of payments. Finally, we’ll analyse how the equilibrium is reached. IS curve: the market for goods and services In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption , investment , public spending and net exports . This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes , the equilibrium would be given by: Y = C (Y- T) + I + G + NX We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production ; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS- LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net exports. Let’s say e is the domestic price of foreign currency or, in
other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate): Y = C (Y- T) + I (Y, i) + G + NX(e) If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any

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