Use the following to answer questions : Exhibit: Risk Premium -(Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially in equilibrium at A with $I S _ { 1 } ^ { * }$ $L M _ { 1 } ^ { * } .$ If there is an increase in the risk premium, then $L M _ { 1 } ^ { * }$ will shift to _____ and $I S _ { 1 } ^ { * }$ will shift to _____. A) $L M _ { 2 } ^ { * } , I S _ { 2 } ^ { * }$ B) $L M _ { 2 } ^ { * } , I S _ { 3 } ^ { * }$ C) $L M _ { 3 } ^ { * } , I S _ { 2 } ^ { * }$ D) $L M _ { 3 } ^ { * } , I S _ { 3 } ^ { * }$

Question

Quizplus · Accepted Answer

An increase in the risk premium would lead to a decrease in capital inflows or an increase in capital outflows, raising the interest rate. This would shift the $LM^*$ curve to the left (to $LM_2^*$) because higher interest rates would reduce the money supply or increase the demand for money, leading to a contraction in the liquidity of the economy. The $IS^*$ curve would shift to the right (to $IS_3^*$) because the increase in the risk premium would make domestic investments less attractive, reducing investment and possibly increasing savings if the economy tries to attract more capital, leading to a decrease in aggregate demand.

Use the Following to Answer Questions : Exhibit: Risk Premium IS1∗I S _ { 1 } ^ { * }IS1∗​

Use the Following to Answer Questions :
Exhibit: Risk Premium $I S _ { 1 } ^ { * }$