Under a flexible exchange rate system, changes in the foreign rate of interest will affect both the financial markets and the real sector. Explain why this comes about using the IS/LM/BP model. What influence, if any, does the degree of international capital mobility have on the results?

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The Answer is Under a flexible exchange rate system, changes in the foreign rate of interest will affect both the financial markets and the real sector due to the interconnectedness of the IS/LM/BP model.

In the IS/LM/BP model, the IS curve represents equilibrium in the goods market, the LM curve represents equilibrium in the money market, and the BP curve represents equilibrium in the balance of payments.

When there is a change in the foreign rate of interest, it affects the BP curve by influencing capital flows. If the foreign rate of interest increases, it becomes more attractive for domestic investors to invest in foreign assets, leading to a capital outflow and a depreciation of the domestic currency. This depreciation makes domestic goods cheaper for foreign consumers, leading to an increase in net exports and a shift in the BP curve.

The change in the BP curve then affects the IS and LM curves. The increase in net exports leads to an increase in aggregate demand, shifting the IS curve to the right. This leads to an increase in output and income in the real sector. Additionally, the depreciation of the domestic currency leads to an increase in the price of imported goods, affecting the money market and shifting the LM curve.

The degree of international capital mobility influences the results by affecting the sensitivity of capital flows to changes in the foreign rate of interest. In a highly mobile capital market, small changes in the foreign rate of interest can lead to large capital flows and significant changes in the exchange rate, which in turn can have a larger impact on the real sector. In contrast, in a less mobile capital market, the impact of changes in the foreign rate of interest on the exchange rate and the real sector may be more muted.

In conclusion, under a flexible exchange rate system, changes in the foreign rate of interest can have significant effects on both the financial markets and the real sector through the interconnectedness of the IS/LM/BP model. The degree of international capital mobility can influence the magnitude of these effects.

Under a Flexible Exchange Rate System, Changes in the Foreign