to point B. At B, there are infinite capital inflows as foreign investors seek to purchase higher returning domestic assets. These investors are exchanging their foreign currency for dollars. The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted foreign exchange and sells dollars. As the Federal Reserve sells the dollars, the Money supply is increased: the LM curve moves to the right and the economy goes from point B to point C. There is a large change in Y from this fiscal expansion. Moral: Fiscal policy is extremely effective in altering the level of domestic output under fixed exchange rates and perfect capital mobility.(Diagram 4, Appendix 1)Flexible Exchange Rates, Perfect Capital Mobility, Increase in Money Supply.The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there are infinite capital outflows as domestic investors seek to purchase higher returning foreign assets. These investors are exchanging their unwanted dollars for foreign exchange. This decreased demand for dollars causes the value of the dollar to fall on foreign exchange markets (i.e. the dollar depreciates, e increases). As e increases, Net Exports increase as domestic goods become relatively cheaper on international markets. As NX increases, Total Expenditures rise and the IS curve shifts to the right. The exchange rate will continue to depreciate, and the IS curve will continue to shift to the right until the capital outflow is halted (i.e. until the domestic interest rate equals the foreign interest rate). The new equilibrium is at C, where domestic output has increased. Moral: Monetary policy is extremely effective in altering the level of domestic output under flexible exchange rates and perfect capital mobility.(Diagram 5, Appendix 1) Flexible Exchange Rates, Perfect Capital Mobility, Increase in G. The increase in Government spending means th...
