A classical IS-LM model of the world economy can be used to show that in a flexible exchange-rate system,a temporary increase in government purchases will cause
A)output and the real interest rate to rise, which reduces net exports but has an ambiguous effect on the real exchange rate.
B)output and the real interest rate to rise, which increases net exports but has an ambiguous effect on the real exchange rate.
C)output to rise and the real interest rate to fall, which reduces net exports and causes the exchange rate to depreciate.
D)the real interest rate to fall, which causes the exchange rate to rise, which reduces net exports.

Question

Quizplus · Accepted Answer

According to the IS-LM model, an increase in government purchases will shift the IS curve to the right, leading to an increase in output and the real interest rate. However, as the real interest rate rises, it will reduce net exports by making domestic goods relatively more expensive, which in turn will lead to a decrease in aggregate demand. The increase in output and real interest rate will also lead to capital inflows, causing the domestic currency to appreciate in the short run. However, the long-run effect on the exchange rate is ambiguous and will depend on the relative adjustment of prices and interest rates between the domestic and foreign economy. Therefore, option A is the correct answer.

A Classical IS-LM Model of the World Economy Can Be