In a situation of flexible exchange rates, other things equal, a shift of the IS curve to the left will lead to __________ of the country's currency if the BP curve is steeper than the LM curve and __________ of the country's currency if the LM curve is steeper than The BP curve.

Question

Quizplus · Accepted Answer

When the IS curve shifts to the left, it leads to a decrease in income and a decrease in the demand for the country's currency. If the BP curve is steeper than the LM curve, this means that a change in the interest rate has a greater effect on the exchange rate than a change in income. In this case, a decrease in income (i.e. a leftward shift in the IS curve) will lead to a greater decrease in the demand for the country's currency, causing its value to depreciate (i.e. choice B).

On the other hand, if the LM curve is steeper than the BP curve, this means that a change in income has a greater effect on the exchange rate than a change in interest rate. In this case, a leftward shift in the IS curve will lead to a decrease in the demand for imports, which causes a surplus in the balance of payments and an increase in demand for the country's currency, causing its value to appreciate (i.e. the opposite of choice B).

In a Situation of Flexible Exchange Rates, Other Things Equal