An increase in government expenditure shifts the IS curve to the right. The shift causes both the local interest rate and income (GDP) to rise. The increase in the local interest rate causes increased capital inflows, and the inflows make the local currency stronger compared toforeign currencies. On the other hand, the higher GDP increases spending on imports, tending to make the currency weaker. Assuming the BoP curve is not as steep as the LM curve (i.e., assuming that capital mobility is relatively strong), the former effect will dominate and the currency will become stronger. The stronger exchange rate also makes foreign goods cheaper compared to local goods. This encourages greater imports and discourages exports, so net exports become lower. As a result of this exchange rate change, the IS curve shifts back toward its original location. The stronger currency also shifts the BoP curve upward, as higher levels of the interest rate would now be consistent with a zero payments surplus in the presence of the stronger currency exchange rate. The LM curve is not at all affected in the short run. The net effect of all this is that, if there is perfect capital mobility, the level of income of the local economy is unchanged from originally, while it has gone up if capital is less than perfectly mobile.
A decrease in government expenditure reverses the process.
