Question

Assuming a flexible exchange rate regime, if the central bank in a foreign country increases its interest rate, then the IS curve of the domestic economy will:

a) shift to the right.
b) shift to the left.
c) will not shift.
d) shift to the right because U.S. exports will decrease.

Answer 1

If the central bank in a foreign country increases its interest rate, the IS curve of the domestic economy will shift to the left.

Step-by-step explanation:

Assuming a flexible exchange rate regime, if the central bank in a foreign country increases its interest rate, the IS curve of the domestic economy will shift to the left. The increase in interest rate in the foreign country will lead to a higher rate of return, which will attract funds from abroad. This will result in a higher demand for the foreign currency and a lower supply, leading to an appreciation of the foreign currency. As a result, imports will become relatively cheaper and exports will become relatively more expensive, causing a decrease in net exports and thus shifting the IS curve to the left.