PS5 - My P Le EC224 Problem Set 5 1 a A reduction in foreign output decreases foreign income thus reduces foreign demand for domestic goods As total

My P Le EC224 Problem Set 5 1. a. A reduction in foreign output decreases foreign income, thus reduces foreign demand for domestic goods. As total demand for domestic goods decreases, IS curve shift to the left decreasing both domestic output and interest rate, and exports decreases, net export decreases, so the net export line shifts down by ∆X. When the IS curve shifts in, the domestic interest rate falls below the foreign interest rate leading to an outﬂow of money (as domestic bonds appear less attractive than foreign bonds, so demand for foreign currency goes up, central bank sell domestic currency to buy foreign currency). This outﬂow ofmoney causes the money supply to decrease, shifting the LM curve up. The domestic interest rate goes up instantly to clear the market. As interest rate increases, investment decreases and output decreases over time. As interest rate increases back to its original level, the original fixed exchange rate is maintained. As exchange rate rises back to its original level, domestic