The inclusion of a strong correlation between the exchange rate and the real rate of interest serves to
A) make the IS curve steeper because higher interest rates mean higher exchange rates and larger net exports.
B) make the IS curve flatter because higher interest rates mean higher exchange rates and smaller net exports.
C) make the LM curve steeper because higher interest rates mean larger inflows of currency and correspondingly greater sensitivity of the demand for money to changes in the interest rate.
D) make the LM curve flatter because higher interest rates mean higher exchange rates and smaller demand for foreign currencies.
E) none of the above.

Question

Quizplus · Accepted Answer

A strong correlation between the exchange rate and the real rate of interest implies that higher interest rates will lead to a higher exchange rate, making domestic goods more expensive for foreigners and foreign goods cheaper for domestic consumers. This reduces net exports, which is a component of the aggregate demand represented in the IS curve. Therefore, the IS curve becomes flatter because a given change in interest rates will have a larger effect on output by influencing the trade balance.

The Inclusion of a Strong Correlation Between the Exchange Rate