Question

Suppose that the central bank has fixed the exchange rate at E₀, but the level of output rises, raising the demand for real monetary assets.This is predicted to put upward pressure on interest rates and the value of the domestic currency.Explain how should the central bank should respond if it wants to maintain the fixed exchange rate?

Answer 1

this will be explain with the help of is-lm and balance of payment curve.

if there is fiscal expansion then IS curve shift rightward which causes increase in interest rate. higher interest rate results to capital inflow and surplus in balance of payment. as a result there is pressure for currency appreciation but to keep exchange rate fixed central bank will intervene by selling domestic currency and purchasing foreign currency. this causes monetory expansion and LM curve shifts rightward. as a result, rate of interest decreases and its return back to world interest rate. but the significant point is that with fiscal expansion output of economy has increases which indicates effectiveness of fiscal policy.