Question

Using a stacked graph (forex market in the upper graph, money market in the lower graph), explain what happens when there is a large influx of capital into a country which wants to maintain a fixed exchange rate, assuming that the inflow is precipitated by an event which leads to a change in expectations. Label all axes, and all curves.

Answer 1

When there is a decrease in the money demand, there will be a shift in the money demand curve to the left which reduces domestic interest rate. Investment spending is increased and so AD shifts to the right. A higher level of GDP and price level is arrived

Now that interest rate on dollar denominated deposits are lower, demand for US dollars is reduced and so there is an expected depreciation of dollar and relative appreciation of euro. This encourages exports and so net exports rise. This is another route where AD shifts to the right. A higher level of GDP and price level is arrived. Now that this decrease is temporary, with increase in real GDP, money demand again shifts to the right and restoring the original rate of interest.