Question

Consider a small, open economy with perfect capital mobility and a fixed exchange rate regime, whose domestic interest rate is currently the same as the foreign
interest rate. Suppose that it adopted the USD as its official currency.

a. Draw the IS-LM diagram for this nation at its general equilibrium point E₁, with equilibrium income level Y₁ and domestic interest rate r_1, what happened if central bank of this country expanded its money supply, please show the changes in the diagram by showing the new E_2, Y₂ and r₂.

And explain in one sentence that what must they do in the foreign exchange market in order to maintain its fixed exchange rate?

Answer 1

Ans. a. An increase in the money supply shifts the LM schedule from LM( M0) to LM(M1). The equilibrium point shifts from E1 to E2 and the real interest rate falls from r1 to r2 and real output increases from y1 to y2. The new equilibrium point is below the BP schedule, indicating a deficit in the balance of payments.

The US central bank, the Federal Reserve, must buy foreign reserve assets( foreign currencies, SDRs, or gold) in the foreign exchange market.