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iiYi*i*YBPFlexibleFixedBPLMIS0IS1IS2IS0IS1LM0LM2Y0Y2i1i1Y1Y1Y0Y2With a flexible exchange rate, the excess demand for the domestic currency causes theexchange rate to appreciate. Since prices are sticky in the short run, neitherPnorP*adjusts,so the appreciation of the nominal exchange rate translates into an appreciation of the realexchange rate (a decrease in competitiveness). As competitiveness deteriorates, the IS curveshifts to the left because demand for exports falls and demand for imports rises. Hence aggre-gate demand is lower at each level of interest rates. The process of exchange-rate appreciationcontinues until investors are content to hold domestic assets, that is, untili=i*. Thus theIS curve continues to shift to the left until it reaches IS2, its original position (IS0and IS2arein exactly the same position).Therefore, once equilibrium in all three markets is restored,neither aggregate outputYnor the interest rateidiffer from their original levels before theincrease in government spending.The adjustment mechanism in the case where the government fixes the exchange rate isvery different. To achieve a fixed exchange rate when capital is perfectly mobile it is necessarythat the government (or central bank) commits to exchange as much foreign for domesticcurrency (or vice versa) at the official exchange rate as market participants request. Withoutany intervention in the foreign exchange market, the domestic interest rate would be abovethe foreign interest ratei*, resulting in a huge inflow of capital to the country. To maintainthe actual exchange rate at its official level in the face of such a capital inflow requires that thegovernment sell its own currency in exchange for foreign currency. This policy action increasesthe amount of domestic currency in circulation, which influences the domestic money market.A rise in the money supply shifts the LM curve to the right, and this lowers domestic interestrates. This process continues until the inflows of capital are discouraged by domestic interestrates falling back to the level of foreign interest rates. Thus the LM curve continues to shift to