addition to being determined by the interest rate, total expenditures are also determined by the exchange rate. Under a fixed exchange rate regime, the IS curve is fixed (unless there is a change in government spending or tax rates, or the government devalues or revalues the currency). Under a flexible exchange rate regime, the price of foreign exchange fluctuates to equate the demand and supply of foreign exchange. Thus, e (domestic price of foreign currency) changes on a frequent basis.Whenever e changes, the IS curve shifts. If e increases (the domestic currency depreciates), X increases, V falls, thus, NX increases, which means total expenditures have risen, therefore the IS curve shifts to the right. If e falls (the domestic currency appreciates), X falls, V rises, thus NX falls and the IS curve shifts to the left. When discussing the effects of various policies (fiscal and monetary), we must be certain of the exchange rate regime: we will get different answers with a flexible regime than with a fixed regime.To examine the effect of trade in financial assets (i.e. capital flows) we need to construct a BP curve. The BP curve shows the various combinations of interest rates and income levels for which the Current Account (CA) and the Capital Account (KA) offset each other (i.e. the Balance of Payments is in equilibrium). The Current Account (CA) is equivalent to the level of net exports and is determined by the domestic level of income (which affects V), the (constant) foreign level of income (which affects X), and the exchange rate (which affects both V and X). As the domestic level of income rises, imports rise while exports stay constant. Thus, as income rises (with e remaining unchanged) NX falls, therefore the CA falls. The Capital Account is determined by the factors that affect capital flows between countries: the rate of return on comparable assets. By assuming that foreign interest rates (i*) are constant and that there are ...
