Changes in government expenditure

An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal.

Increased government expenditure shifts the IS curve to the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate (value of the domestic currency) as foreign funds start to flow in, attracted by the higher interest rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currency using domestic funds in order to shift the LM curve to the right. In the end, the exchange rate stays the same but the general income in the economy increases. In the IS-LM-BoP graph, the IS curve has been shifted exogenously by the fiscal authority, and the IS and BoP curves determine the final resting place of the system; the LM curve merely passively reacts.

The reverse process applies when government expenditure decreases.