Consider the IS-LM-BP model, where the BP curve is horizontal with perfect capital mobility. A decrease...

Consider the IS-LM-BP model, where the BP curve is horizontal with perfect capital mobility. A decrease in foreign interest rates will lead to a BoP deficit and a depletion in the Central Bank’s official foreign exchange reserves under fixed exchange rate regime.

it is a true/false question and could you explain it briefly please?

Expert Solution

Answer to the following question:

False. A decrease in the foreign interest rate implies that the domestic interest rate is relatively higher than the foreign interest rate. This higher interest rate will attract foreign capital. Capital inflow will take place. This will increase the demand for domestic currency, which will appeciate the domestic durrency over foreign currency. The exchange rate falls. The central bank has to maintain the exchange rate at fixed level (because of fixed exchange rate) so it will sell the domestic currency for foreign currency and raises the supply of domestic currency. This in turn will lead to a dpletion of the domestic currency reserve and the foreign currency reserve will go up.

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Rahul Sunny answered 2 years ago

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