Answer to Question #205173 in Macroeconomics for Harshal Bansode

Question

Use the IS-LM-BP model (assuming perfect capital mobility) to show that under fixed exchange rates, monetary policy does not work.

Answer 1

The IS-LM-BP model (also known as IS-ML-BoP or Mundell-Fleming model) is an extension of the IS-LM model, which was formulated by the economists Robert Mundell and Marcus Fleming, it has special focus on the effectiveness of the monetary policy under fixed and flexible Exchange Rates in a situation of perfect mobility of capital;

Under fixed exchange rate, an expansionary monetary policy will shift the LM curve to LM’, as illustrated below;

This makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit.

Since exchange rates are fixed, government intervention is required: the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM curve to its original position (which makes the equilibrium go to E₂).

Conclusion: Monetary policy has therefore no effect under these circumstances.