V. Answers to End of Chapter Questions1. Achieving a balance-of-payments surplus requires that the sum of the capitalaccount balance and current account balance is positive, which requires a higher interest rate to attract greater capital inflows and lower real income to dampen import spending. Consequently, the BP schedule would lie above and to the left of the position it otherwise would have occupied if the external-balanceobjective were to ensure only a balance-of- payments equilibrium. Undoubtedly, if the central bank felt pressure to sterilize under the latter objective, the pressure to do so would be greater if it seeks to attain a balance-of-payments surplus, which would require the central bank to steadily acquire foreign-exchangereserves. In the absence of sterilization, the nation's money stock would steadily decline.2. In this situation, variations in the domestic interest rate relative to interest rates inother nations would have not effect on the nation's capital account balance and its balance of payments. Its BP schedule, therefore, would be vertical. Anexpansionary fiscal policy, given a fixed exchange rate (as assumed in thischapter), would cause the IS schedule to shift rightward, initially inducing a rise in equilibrium real income. This, however, would cause import spending toincrease, and the nation would experience a balance-of-payments deficit, which would place downward pressure on the value of its currency. To prevent achange in the exchange rate, the central bank would have to sell foreign exchange reserves. If this intervention is unsterilized, then the nation's money stock would decline, ultimately causing the LM schedule to shift back too a final IS-LMequilibrium at a point vertically above the initial equilibrium point, along thevertical BP schedule.3. A reduction in the quantity of money shifts the LM schedule leftward. At thenew IS-LM equilibrium, the nominal interest rate rises and real income declines.Irrespective of the shape of the BP schedule, this would result in a balance ofpayment surplus, which would tend to place upward pressure on the value of the nation's currency. To maintain a fixed exchange rate, the central bank would have to purchase foreign exchange reserves. If this foreign-exchange-market intervention is unsterilized, then the nation's money stock increases, causing the LM schedule to shift back to the right. Ultimately, the original IS-LMequilibrium is re-attained.4. If capital is highly mobile, a drop in government spending will likely cause aprivate payments deficit. The fall in income will cause a decrease in imports anda trade surplus. As the domestic interest rate increases, however, the capitaloutflow will lead to a private payments deficit. If capital is not mobile, thecapital outflows are likely not large enough to counteract the effect of a drop in imports. Therefore, a private payments surplus would result.5. A contractionary fiscal policy action, such as a reduction in government spending,causes the IS schedule to shift leftward, inducing an initial decline in the nominal interest rate and reduction in real income. As a result, there is a capital outflow and fall in import spending. Because capital is highly mobile, thecapital-outflow effect dominates, and the nation experiences abalance-of-payments deficit. This places downward pressure on the value of the nation's currency, which induces the central bank to sell foreign exchange reserves.If this action is unsterilized, then the nation's money stock declines, causing the LM schedule to shift back to the left was well, which yields a new IS-LMequilibrium along the BP schedule to the left of the original equilibrium point.6. If, on the other hand, there is low capital mobility, the nation experiences abalance-of-payments surplus. This places upward pressure on the value of the nation's currency, which induces the central bank to purchase foreign exchange reserves. If this action is unsterilized, then the nation's money stock rises,causing the LM schedule to shift to the right.7. A foreign fiscal contraction leads to the foreign IS schedule to shift to the left,resulting in a lower y* and r*. Financial resources will flow from the foreign country to the domestic country, placing pressure on the domestic currency to gain value. In response, therefore, the domestic central bank purchases foreignexchange to maintain the fixed exchange rate. Consequently, the domesticmoney supply rises, leading the domestic country's LM schedule to shift rightward.The lower foreign income level also leads to lower domestic exports (few foreign imports). Therefore, the domestic country's IS schedule shifts left and theforeign country's IS schedule shifts to the right. In both countries' graphs, the BP schedule shifts down to reflect lower interest rates.8. A domestic fiscal contraction leads to a leftward shift in the domestic ISschedule, resulting in a lower domestic income level and interest rate.Consequently, domestic imports fall (foreign exports fall). Further, as foreign exports fall, the foreign IS schedule shifts left and decreases foreign income. In turn, domestic exports fall and domestic IS schedule shifts further left. Thelower domestic interest rate leads to a capital outflow of the domestic country and puts pressure on the value of the domestic currency to fall. The domestic central bank responds by selling foreign exchange in order to maintain the fixed exchange rate. As the domestic money supply falls, the domestic LM schedule shifts to the left. Finally, both countries' BP lines shift down to the new lower equilibrium interest rate.9. A domestic monetary expansion shifts the domestic LM schedule rightward,which reduces the domestic interest rate. This tends to induce a domesticbalance-of-payments deficit and places downward pressure on the value of thedomestic currency relative to the foreign currency. Now, both central banks work together to keep the exchange rate unchanged, so the foreign central bank must increase its own money stock, shifting its LM schedule to the right and reducing the equilibrium foreign interest rate as well. In the end, therefore, both BP schedules shift downward, and the nations' interest rates are equalized, sopayments imbalances are eliminated. Equilibrium real income rises in bothnations, so there is a locomotive effect on the foreign country as a result of the domestic monetary expansion, assuming unchanging price levels.10. A domestic fiscal expansion causes the domestic IS schedule to shift to the right, which raises the domestic interest rate. This tends to induce a domesticbalance-of-payments surplus and places upward pressure on the value of the domestic currency relative to the foreign currency. Both central banks work together to keep the exchange rate fixed, so the foreign central bank must reduce its own money stock, shifting its LM schedule leftward and increasing the foreign interest rate as well. In the end, both BP schedules shift upward, and the nations' interest rates are equalized, so payments imbalances are eliminated. Equilibrium real income rises in the domestic country but declines in the foreign country. Thus, there is abeggar-thy-neighbor effect on the foreign country as a result of the domestic fiscal expansion, assuming unchanging price levels.。