Changes in the global interest rate
An increase in the global interest rate shifts the BoP curve upward and causes capital flows out of the local economy. This depreciates the local currency and boosts net exports, shifting the IS curve to the right. Under less than perfect capital mobility, the depreciated exchange rate shifts the BoP curve somewhat back down. The net effect is an increase in income and the local interest rate. Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate. When the latter goes up, the BoP curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the IS curve to the location where it crosses the new BoP curve at its intersection with the unchanged LM curve; now the domestic interest rate equals the new level of the global interest rate. A decrease in the global interest rate causes the reverse to occur. Under a fixed exchange rate regime In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero; the exchange rate e is exogenously given, while the variable BoP is endogenous. Under the fixed exchange rate system, the central bank operates in the foreign exchange market to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. Again,this keeps the exchange rate at its targeted level.
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