BOP in IS-LM Model
Internal Balance:
The attainment of the level of real income consistent with the economy’s long run growth path.

BOP in IS-LM Model
External Balance:
The attainment of some objective for private international goods, services, income, and assets.

BOP in IS-LM Model
External Balance means different things for different policymakers.

BOP in IS-LM Model
External Balance means different things for different policymakers.
could mean:
• achieving trade surplus, or
It

BOP in IS-LM Model
External Balance means different things for different policymakers. It could mean:
• achieving trade surplus, or
• achieving surplus in their current account
(international trade and transfer of goods and services and flows of income), or

BOP in IS-LM Model
External Balance means different things for different policymakers. It could mean:
• achieving trade surplus, or
• achieving surplus in their current account (international trade and transfer of goods and services and flows of income), or
• achieving balance in one or both

BOP in IS-LM Model
External Balance means different things for different policymakers. It could mean:
• achieving trade surplus, or
• achieving surplus in their current account (international trade and transfer of goods and services and flows of income), or
• achieving balance in one or both
• achieving balance in private transactions such as zero balance after current and capital accounts are added to prevent government obligations.

BP Schedule
A set of real income-nominal interest rate combinations that maintain a zero balance for private payments - sometimes called a
“balance of payments equilibrium” in the balance of payments accounts.

BP Schedule
Any point (A or B) on the BP schedule entails external balance: zero private payment.
Interest rate
BP
B r
2
A r
1
Real income y
1 y
2

BP Schedule
Starting from point A, if income rises to y
2
, imports rises to higher level and a Deficit will develop (C).
This requires a higher interest rate to attract foreign funds to cancel the trade deficit (B)
B BP
A
C
Real income y
1 y
2

Interest rate
BP Schedule
BP
A
B
C
Real income y
1 y
2

BP Schedule
Assume the following dilemma:
• full employment income is at Y*
• equilibrium level of income is Y
2
• equilibrium level of income that satisfies equilibrium in the BP is Y
1 .
• What should the central bank do?

Interest rate
BP Schedule
BP
LM y
1 y
2
Y *
IS
Real income

Expansionary Monetary Policy would lead to full employment but larger trade deficits
Interest rate
BP
LM
LM ’
IS
Real income y
1 y
2
Y *

Contractionary Monetary Policy would exacerbate employment but solves trade deficit problem
Interest rate
BP
LM ’
LM y
1 y
2
Y *
IS
Real income