IS-LM with exchange rates: why policy works completely differently under fixed vs. floating regimes.
Warming up the engine…
IS-LM opened to the world: with capital mobile across borders, the exchange-rate regime decides which policy works. Floating rates make monetary policy powerful and fiscal policy weak; fixed rates do the reverse.
IS*: Y = C + I + G + NX(e) ; LM*: M/P = L(r*, Y) with r pinned to the world rate
Under floating rates, fiscal expansion pulls in foreign capital, appreciates the currency, and the lost net exports undo the stimulus; monetary expansion depreciates the currency and works doubly. Under fixed rates, the central bank must defend the peg, so it loses monetary independence entirely: the policy trilemma in action.
First state the regime and capital mobility, then trace the exchange-rate step explicitly. 'Fiscal ineffective under floating, monetary ineffective under fixed' is the result to prove, not just assert.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Also in Advanced Macro & Growth
Equilibrium at Y 53, r 4.7.
Equilibrium: Y* = 53.3, r* = 4.7
Current equations
IS-LM goes global: the dashed BP line marks the world interest rate. Whenever domestic policy pushes r off that line, capital floods in or out, and the exchange rateexchange rateThe price of one currency in terms of another. takes over the story.
Source: Blanchard, Macroeconomics, ch. 19-20