Use the standard IS-LM-FE framework and assume the country begins at a triple intersection. Show using the graph and explain in words the effect that an increase in the country's money supply will have on domestic interest rates, output levels, and the official settlements balance (before we consider the implications of pressure on the country's exchange rate).

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: The LM curve shifts to the right, and the country moves to a new short-run equilibrium at the intersection of the IS curve and the new LM curve. The domestic interest rate decreases, and real gross domestic product (GDP) increases. The new IS-LM intersection is to the right of the FE curve, so the official settlements balance goes into deficit.

With the increase in the money supply, the larger money supply is temporarily greater than money demand. To bring about equilibrium in the money market, interest rates must fall. The fall in interest rates increases interest-sensitive spending, so the GDP level increases.

The reduction in the country's interest rate drives a capital outflow (the nonofficial financial account shifts toward deficit), and the increase in real GDP increases imports (the current account shifts toward deficit), so the official settlements balance goes into deficit.