Draw and label accurately the IS-LM-FX graphs in a and b. Using the

graph, show the effect of each change on equilibrium Y, i, and E and note the

direction of change from one equilibrium to the next. Assume the price level is fixed. Explain in a few sentences what happened in each instance.

a. Fixed exchange rate; decrease in government spending

b. Flexible exchange rate; decrease in money supply.

EXAMPLE:

(a) ISLM Diagram (b) FX Market Interest Domestic rate. r' t M and foreign returns I5 FR 1'; Output, income, Y E1 Exchange rate, E Equilibrium in the ISLMFX Model In panel (a), the IS and LM curves are both drawn. The goods and forex markets are in equilibrium when the economy is on the IS curve. The money market is in equilibrium when the economy is on the LM curve. Both markets are in equilibrium if and only if the economy is at point 1, the unique point of intersection of IS and LM. In panel (b), the forex (FX) market is shown. The domestic return, DR, in the forex market equals the money market interest rate. Equilibrium is at point 1' where the foreign return FR equals domestic return