The IS-LM-BB Model

and the Bretton Woods System

How BOP disequilibria bring deficit countries in a

position of asymmetric disadvantage vis-à-vis surplus
countries, and potentially confront policy makers with
domestic policy conflicts.
Note:
While explained in the context of the Bretton Woods System,
the analysis holds in general
FOR ANY GROUP OF COUNTRIES WHICH TOGETHER ASPIRE TO
Copyright (c) R. Gigengack

MAINTAIN A REGIME OF FIXED EXCHANGE RATES!

http://www.eco.rug.nl/medewerk/gigengack
 CASE 1:
The Deficit Country

Copyright (c) R. Gigengack

http://www.eco.rug.nl/medewerk/gigengack
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is temporary, the policy response is:
r
STERILIZE!

BB LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is temporary, the policy response is:
r
STERILIZE!

BB BB’ LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is of medium term duration, the
r amount of foreign reserves may be deficient; policy response is:
BORROW FROM THE IMF!

BB LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is of medium term duration, the
r amount of foreign reserves may be deficient; policy response is:
BORROW FROM THE IMF!

BB BB’ LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is “FUNDAMENTAL”, then:
r EMPLOY DOMESTIC MACRO-POLICY TO CORRECT THE
EXTERNAL IMBALANCE

BB LM

rF

IS

YF Y
 Copyright (c) 1999 R. Gigengack
http://www.eco.rug.nl/medewerk/gigengack

The initial domestic equilibrium corresponds with a BOP deficit. a.r.m.gigengack@eco.rug.nl

If this “external disequilibrium” is “FUNDAMENTAL”, then:

r EMPLOY DOMESTIC MACRO-POLICY TO CORRECT THE
EXTERNAL IMBALANCE

BB LM’ LM

rU
rF

IS

YU YF Y
 The initial domestic equilibrium corresponds with a BOP deficit.
If this “external disequilibrium” is “FUNDAMENTAL”, then:
r EMPLOY DOMESTIC MACRO-POLICY TO CORRECT THE
EXTERNAL IMBALANCE

BB LM” LM’ LM

r*

rU
rF

IS”

IS

YU YF Y
 NOTE: It makes no sense to use FISCAL POLICY to secure external
BOP equilibrium… the fall in Y is larger, and
r YOU CANNOT FOLLOW UP WITH MONETARY POLICY TO
SECURE FULL EMPLOYMENT !

BB LM

rF

rU

IS
IS’

YU YF Y
 The Deficit Country
can face a serious policy dilemma;
it can find itself in a so-called
“Meade Policy Conflict”….

Copyright (c) R. Gigengack

http://www.eco.rug.nl/medewerk/gigengack
 If the initial domestic equilibrium corresponds with a BOP deficit
and domestic unemployment, there is both
r “internal” and “external disequilibrium”
This situation is a MEADE CONFLICT CASE.

BB LM

r*

IS

Y* YF Y
 The MEADE CONFLICT CASE for the deficit country can be
resolved with a DEVALUATION….
r

BB LM

r*

IS

Y* YF Y
 The MEADE CONFLICT CASE for the deficit country can be
resolved with a DEVALUATION….
r

BB BB’ LM

r*

IS’

IS

Y* YF Y
 But the deficit country may be in “internal” and “external
disequilibrium” without a conflict….
r

BB LM

r*

IS

YF Y* Y
 But the deficit country may be in “internal” and “external
disequilibrium” without a conflict….
r

BB LM’ LM

r*

IS

YF Y* Y
 CASE 2:
The Surplus Country

Copyright (c) R. Gigengack

http://www.eco.rug.nl/medewerk/gigengack
 The initial domestic equilibrium corresponds with a BOP surplus.
If this “external disequilibrium” is temporary, the policy response is:
r
Who cares????…. if necessary, STERILIZE!

BB LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP surplus.
If this “external disequilibrium” is of medium term duration,
r Who cares???…. if necessary, just STERILIZE!

BB LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP surplus.
If this “external disequilibrium” is “FUNDAMENTAL”, then:
r Maybe care a little…. but there is only a slight dilemma, since
obtaining BOP equilibrium STIMULATES THE ECONOMY

BB LM

rF

IS

YF Y
 The initial domestic equilibrium corresponds with a BOP surplus.
If this “external disequilibrium” is “FUNDAMENTAL”, then:
r Maybe care a little…. but there is only a slight dilemma, since
obtaining BOP equilibrium STIMULATES THE ECONOMY

BB LM LM’

rF
r**

IS

Y F Y ** Y
 The Surplus Country
can also find itself in a “Meade Conflict”….

Copyright (c) R. Gigengack

http://www.eco.rug.nl/medewerk/gigengack
 If the initial domestic equilibrium corresponds with a BOP surplus
and domestic inflation, there is both
r “internal” and “external disequilibrium”
This situation is also a MEADE CONFLICT CASE.

BB LM

r*

IS

YF Y* Y
 But the conflict is relatively moot… priority can be given to the
domestic policy objective….
r
Who cares if the surplus get larger???

LM’ BB LM

r*

IS’ IS

YF Y* Y
 However… if policy makers do care, they can obtain internal and
external balance via a currency REVALUATION.
r

BB LM

r*

IS

YF Y* Y
 However… if policy makers do care, they can obtain internal and
external balance via a currency REVALUATION.
r

BB’ BB LM

r*

r**

IS’ IS

YF Y* Y
 The Surplus Country
can also find itself in internal and external disequilibrium,
but without any serious policy conflict….

Copyright (c) R. Gigengack

http://www.eco.rug.nl/medewerk/gigengack
 If the initial domestic disequilibrium corresponds with a BOP
surplus and domestic unemployment, there is no conflict…
r
expansionary policy can help deal with both simultaneously!

BB LM

r*

IS

Y* YF Y
 If the initial domestic disequilibrium corresponds with a BOP
surplus and domestic unemployment, there is no conflict…
r
Expansionary policy can help deal with both simultaneously!

BB LM LM’

r*

IS IS’

Y* YF Y
This ends the slide show.
 This slide show has been designed to accompany courses in
International Economics
at the University of Groningen.

Other slide shows and animations of useful graphs for economic analysis,
especially international economics, can be viewed elsewhere on:
HTTP://WWW.ECO.RUG.NL/~GIGENGACK

This slide show was created by: R. Gigengack  1999-2006

E-mail: A.R.M.Gigengack@RUG.NL