The figure below shows an IS-LM-FE model for an economy with fixed exchange rates. Initially the economy is at point A, a triple intersection. Here, the FE curve is steeper than the LM curve. If monetary authorities are unable to sterilize, output will end up: A)at Y₁. B)to the left of Y₁. C)To the right of Y1. D)at Y₀.

Question

Quizplus · Accepted Answer

Given that the FE curve is steeper than the LM curve at point A. If monetary authorities are unable to sterilize (i.e. unable to offset or neutralize the impacts of their foreign exchange operations on the domestic money supply), then there will be an increase in money supply (assuming there is a balance of payments surplus or an inward shift in the LM curve) which will cause the LM curve to shift to the right. However, the FE curve remains fixed. The new intersection point of the LM curve and the FE curve will be to the left of the original triple intersection point A, as shown in Y₁. At this new equilibrium point, both output and interest rate increase while the exchange rate remains fixed.

The Figure Below Shows an IS-LM-FE Model for an Economy