Floating Rate Regime
Central bank allows rate to be determined by market forces.
- \(\Delta M\): An increase in the money supply would shift the LM curve to the right, reducing the domestic interest rate relative to the global interest rate. Capital outflow would increase, which increases the real exchange rate, and ultimately the IS curve would shift to the right until the domestic interest rate is equal to the global interest rate. The opposite effects would occur for a decrease, as shown below,
- \(\Delta G\): An increase in government spending would shift the IS curve out. Domestic interest rates would rise with output, however, this would attract foreign capital. Domestic currency would then appreciate due to the inflow and it's now more expensive for domestic producers to export, so next exports will decrease. Overall, the IS curve would shift back again and there would be no impact on domestic output or interest rates. The opposite, a decrease in government spending, can be shown below:
- \(\Delta i^*\): An increase in foreign interest rates would shift the BoP curve up to that level, causing capital outflows. Domestic currency would depreciate, causing net exports to increase and shifting the IS curve rightward. The exchange rates shift enough for the IS curve to shift out to intersect the higher BoP curve. Oppositely, the impact of a decrease in foreign interest rates can be shown below:
Fixed Rate Regime
Central bank announce and actively keep exchange rates.
- \(\Delta M\): The money supply is usually kept at predetermined levels by the monetary authority based upon past international flows. This keeps consistent exchange rates.
- \(\Delta G\): In case of an increase, the IS curve would shift rightward. The domestic interest rate rises, triggering the inflow of foreign capital, thus the monetary authority has to buy it up to keep the rate consistent. This causes a reactive LM curve to shift to the right. Same for the opposite effect.
- \(\Delta i ^*\): Once again, the LM curve plays a passive role and outcomes are determine by the IS-BoP interaction.