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I'm currently learning the Mundell Fleming model, and so from my textbook and other sources I've figured out the effect of increase in money supply and government expenditure increase for the following conditions:

  1. Fixed & floating exchange rates (perfect capital mobility / BP horizontal)
  2. Fixed & floating exchange rates (imperfect capital mobility, BP flatter than LM curve)
  3. Fixed exchange rate (imperfect capital mobility, BP steeper than LM curve)

I'm stuck at figuring out the effect of a fiscal expansion in the case of floating exchange rate with the BP curve steeper than the LM curve. My textbook has not mentioned it but I'd like to how it'd turn out.

Here's my guess:

enter image description here

The economy is initially at the point A. There is fiscal expansion:

  1. IS moves to the right (1 to 2)
  2. At B, there is a deficit in BOP, which causes the domestic currency to depreciate.
  3. This increases exports and decreases imports, which causes net exports to increase, which then causes Y to increase, which shifts IS further up (IS 3).
  4. At B, because of increase in net exports, BOP improve and so BP also shifts to the right.
  5. The economy settles at the new equilibrium C.

Am I correct?

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Yes, the diagram represented in the question is correct. Assuming imperfect capital mobility (with the BP curve steeper than the LM curve), an increase in G will:

  1. Move the IS curve to the right.
  2. At this point (B), there will be a BOP deficit because the point is below the BP curve.
  3. Thus, the domestic currency will depreciate.
  4. Exports will rise, imports will decrease and thus net exports will rise.
  5. This will have two effects: (a) this will shift the IS curve further to the right (because net exports have risen, and so Y has risen) and (b) this will shift the BP curve to the right (because net exports have risen, improving the current account balance).
  6. The new equilibrium is at C.

I found a better diagram illustrating this (the diagram includes two cases: one with the BP flatter than the LM and one steeper; the points and movements marked with an asterik (*) are the ones concerned with the case of BP being steeper than the LM). (Image Courtesy of Polinomics: http://policonomics.com/is-lm-bp/)

enter image description here

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