Question
Under a fixed exchange rate system with perfect capital
mobility, what happens when the government increases its spending?Solution
In a fixed exchange rate system with perfect capital mobility, an increase in government spending shifts the IS curve to the right, increasing output and the interest rate. However, because capital is perfectly mobile, the higher domestic interest rate would attract foreign capital, leading to upward pressure on the exchange rate (appreciation). To maintain the fixed exchange rate, the central bank intervenes by increasing the money supply, which shifts the LM curve to the right, lowering the interest rate back to the world interest rate.
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