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      Question

      Under a fixed exchange rate system with perfect capital

      mobility, what happens when the government increases its spending?
      A The domestic currency appreciates. Correct Answer Incorrect Answer
      B The central bank must increase the money supply to maintain the fixed exchange rate Correct Answer Incorrect Answer
      C The central bank must decrease the money supply to maintain the fixed exchange rate. Correct Answer Incorrect Answer
      D The domestic interest rate rises above the world interest rate. Correct Answer Incorrect Answer

      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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