no expectations that the exchange rate will change, a rise in domestic interest rates will attract capital here (K inflow) while a fall in domestic interest rates will attract capital to foreign countries (K outflow).The BP curve is drawn for a given exchange rate and a given foreign interest rate. (Diagram 1, Appendix 1)The slope of the BP curve (Diagram 2, Appendix 1) has 3 ranges, characterizing the degree of capital mobility in the economy. The BP is perfectly horizontal when capital is perfectly mobile. This situation occurs when financial assets are perfect substitute across countries. Any small deviation in the domestic interest rate from the foreign interest rate results in an infinite amount of capital flows. If the domestic interest rate is lower than the foreign interest rate, there are an infinite amount of capital outflows. If the domestic interest rate is higher than the foreign interest rate, there are an infinite amount of capital inflows. Obviously, whenever there are an infinite amount of capital flows, there is very strong pressure on the exchange rate to change. Under a fixed exchange rate regime, the Central Bank will have to buy or sell sufficient quantities of domestic currency to counteract this pressure on the exchange rate. Under a flexible exchange rate regime, the price of foreign exchange will adjust.When capital is mobile (but not perfectly mobile) the BP curve is not perfectly horizontal, but is flatter than the LM curve. Assets are not perfect substitutes across countries. Immobile capital occurs when the BP curve is steeper than the LM curve. As we will see below, the degree of capital mobility has a bearing on the outcome of various fiscal and monetary policies.To sum up, the rules for shifts in the curves are as follows: The IS Curve.The IS shifts right when there is an increase in G or the exchange rate depreciates (i.e. e increases). The IS curve shifts left when there is an increase in the proportio...
