Question

Under a flexible-rate system, when the BP curve is flatter than the LM curve (i.e., there is relative capital mobility), an autonomous increase in foreign interest rates will have what impacts on the domestic interest rate and domestic national income?

Select one:

a. domestic interest rate will increase, domestic national income will decrease

b. domestic interest rate will increase, domestic national income will not change

c. domestic interest rate will increase, domestic national income will increase

d. domestic interest rate will not change, domestic national income will decrease

Answer 1

It shall be noted that under the flexible exchange rate system, the exchange rate is market-determined.

When the BP curve is flatter than the LM curve and when there is an autonomous increase in foreign interest rate, the relative difference between the foreign interest rate and the domestic interest rate would increase. There would be the capital flight that would take place from the domestic economy to abroad to make a quick return on foreign assets.

As the capital flight takes place, there is an increased demand for foreign currency as a result of this, the domestic currency depreciation would take place.

This would ensure that exports become relatively cheaper, thereby giving a boost to the exports and curb the imports as imports become relatively expensive. Thus, domestic income would increase.

To ensure BP equilibrium once again, the domestic interest rate would rise and would become eventually equal to the increased foreign interest rate.

Thus, with an autonomous increase in the foreign interest rate, the domestic interest rate will increase, domestic national income will increase.

Hence, the correct answer is c. the domestic interest rate will increase, domestic national income will increase.