Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
 
Figure 10.1: Effect of Exchange Rates on Aggregate Demand 
With perfect capital mobility and flexible rates, capital flows 
have a strong impact on demand. If home rates fall below i
f
, there 
are capital outflow leading to exchange depreciation, a gain in 
competitiveness, and hence a rise in demand for domestic goods 
Output
i
f
i
i
Appreciation
Depreciation
BP
0
IS

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shown by the rightward shift of the IS schedule. Conversely, if 
interest rates go have i
f
the capital inflows lead to appreciation, loss 
of competitiveness and a decline in demand for domestic goods 
shown by the leftward IS curve. 
The arrows in the Figure above indicate the movement of 
aggregate demand in response to the interest rate (i). 
Now let us explore how various changes affect the level of 
output, interest rate and exchange rate in the light of the Mundell 
– 
Fleming Model. 
Increase in Exports 
Suppose world demand for a country‘s exports rise. This is 
real disturbance which originates in that country‘s goods market. 
The following diagram illustrates the sequence of changes 
generated by this ‗real disturbance.‘ 
 
Figure 10.2: Effects of an increase in the demand for exports 
A rise in foreign demand for our goods, at the initial 
exchange rate and interest rate at point E, creates an excess 
demand for goods. The IS schedule shifts out to IS', and the new 
goods and money market equilibrium is at point E'. But at E' our 
interest rate exceeds that of abroad. Capital will tend to flow into 
our economy in response to the increased interest rate, and the 
resulting balance of payments surplus leads to currency 
appreciation. The appreciation means that we become less 
competitive. The IS schedule starts shifting back as a result of the 
appreciation, and the process continues until the initial equilibrium 
at E is reached again. In the end, increased exports (or a fiscal