Just a short note as a backgrounder for the current Canadian debate about fiscal policy.
This is totally unoriginal boring textbook stuff (at least I hope it is, anyway). Prerequisite: intermediate macro (or special permission to skip to the results if you promise not to ask me daft questions about where they came from).
The simple second year textbook Mundell-Fleming ISLMBP model under flexible exchange rates makes two assumptions that we need to modify:
1. The simple textbook version assumes the money supply is fixed. In other words, it assumes the Bank of Canada targets the money supply. But the Bank of Canada targets the inflation rate, and it adjusts the money supply (adjusts the nominal interest rate and allows the stock of money to adjust, if you prefer) to keep its internal forecast of the inflation rate at 2%. The easiest way to build this into the textbook picture is to assume the Bank of Canada shifts the LM curve to try to keep the ISLMBP equilibrium point at (what the Bank of Canada thinks is) potential output Y*.
2. The simple (or simplest) textbook version (normally) assumes the exchange rate is not expected to change. The expected rate of appreciation/depreciation is assumed to be zero, so the BP curve is horizontal at the exogenous world interest rate. But if the change in fiscal policy (e.g. an increase in Government expenditure) is temporary, the exchange rate will appreciate when G increases, and will depreciate again in future when G falls back to normal. And if the foreign exchange market is not "dumber than a sack of hammers" (in Stephen Gordon's unforgettable phrase) it might figure this out. If so, the expected exchange rate depreciation following the initial (surprise) appreciation will cause the BP curve to shift up. Canadian interest rates will rise relative to world interest rates, because the Looney is expected to be depreciating back to its original level. But if the change in fiscal policy is expected to be "permanent" (or at least be wound down slowly enough that this effect can be ignored) the BP curve will not shift up.