In the IS-LM-BP model, suppose that the balance of payments equilibrium condition is

a1E=a2Y + b (i-i(star)) = 0

where E is the nominal exchange rate, Y is output, i is home interest rate and i(star) is foreign interest rate. The three parameters, a1, a2 and b, are all positive. Parameter a2 is the marginal propensity to import. Parameter b is the degree of capital mobility.

(a) Derive the equation of the BP curve.

(b) What is the slope of the BP curve?

(c) What would happen to the slope of the BP curve if:

i. the marginal propensity to import increased?

ii. capital mobility increased?

(d) Use the IS-LM-BP diagram to examine the effects of a sudden drop in consumer confidence when the economy is on a flexible exchange rate. Assume that capital mobility is high but not perfect (the BP curve is positively sloping but flatter than the LM curve). (5 point