An economy starts in an equilibrium condition in three markets under flexible exchange rate regime and perfect capital mobility.If the central bank in a foreign country increases its interest rate,what would happen in the domestic country?

Question

Quizplus · Accepted Answer

Under flexible exchange rate regime and perfect capital mobility, an increase in the interest rate in a foreign country would lead to an outflow of capital from the domestic country as investors would seek higher returns abroad. This would cause a reduction in the demand for the domestic currency and lead to its depreciation. As a result, exports become cheaper and imports become more expensive, leading to an increase in net exports and, thus, a shift of the IS curve to the right. Therefore, choice A is the correct answer. Choice B describes the opposite effect, and choices C and D suggest changes in the LM curve, which would only be affected by changes in the domestic money supply or demand for money, not by foreign interest rate changes.

An Economy Starts in an Equilibrium Condition in Three Markets