Under A Flexible Rate System When The BP Curve Is Flatter

3under A Flexible Rate System When The Bp Curve Is Flatter Than The L

Under a flexible-rate system, when the BP curve is flatter than the LM curve (i.e., there is relative capital mobility), an autonomous increase in foreign interest rates will have specific impacts on the domestic interest rate and domestic national income. When foreign interest rates rise independently, capital tends to flow out of the domestic country to seek higher returns abroad. This capital outflow leads to depreciation of the domestic currency under flexible exchange rates, affecting the domestic interest rates and income levels.

The BP curve, representing balance-of-payments equilibrium, being flatter than the LM curve, suggests that the country exhibits high capital mobility. Consequently, changes abroad significantly influence domestic financial conditions. An increase in foreign interest rates makes foreign assets more attractive, prompting capital to leave the domestic economy, which results in depreciation of the domestic currency, an increase in domestic interest rates, and a subsequent effect on national income.

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In the context of international macroeconomics, understanding the interplay between the balance of payments (BP) curve and the LM curve under a flexible exchange rate regime is crucial. The BP curve reflects equilibrium in the balance of payments, with its slope indicating the degree of capital mobility. When the BP curve is flatter than the LM curve, it signifies high capital mobility, meaning that international capital flows respond readily to differences in interest rates and exchange rates. This scenario influences how changes in foreign interest rates impact the domestic economy, particularly the domestic interest rate and national income.

When foreign interest rates increase independently—a scenario known as an autonomous change—the impact on the domestic economy in a regime where the BP curve is flatter than the LM curve can be profound. This setting implies that international capital mobility is high enough that small shifts in interest rates abroad can lead to substantial capital movements across borders. As foreign interest rates rise, investors seek higher yields in foreign markets, leading to capital outflows from the domestic economy. These outflows cause depreciation of the domestic currency under flexible exchange rate systems, making domestic exports cheaper and imports more expensive, which tends to enhance net exports and boost domestic income.

Simultaneously, the capital outflow results in an increase in the domestic interest rate. To prevent excessive depreciation of the currency or large capital outflows, the domestic interest rate often rises as well. The increase in domestic interest rates can attract foreign capital, partially offsetting the initial outflow, but the overall effect depends on the degree of capital mobility and other macroeconomic factors.

Empirical and theoretical models support this view. High capital mobility implies that the domestic interest rate will tend to increase as foreign interest rates rise, due to the need for the domestic financial market to attract or retain capital. The increase in interest rates can lead to higher borrowing costs domestically, which may dampen private investment and reduce domestic consumption, potentially decreasing national income in the short term. Conversely, the depreciation of the domestic currency resulting from capital outflows can enhance exports, stimulating economic growth in the long term.

Therefore, under a flexible exchange rate system with a flatter BP curve, an autonomous increase in foreign interest rates primarily results in an increase in the domestic interest rate, owing to the high capital mobility and the need to balance international capital flows. The effect on domestic national income, however, is more nuanced. While initially, the rise in interest rates might reduce investment and consumption, the resulting depreciation of the domestic currency can lead to an improvement in net exports, potentially increasing national income over time.

This complex interplay indicates that the immediate effect of rising foreign interest rates under high capital mobility is an increase in domestic interest rates and potentially a rise in domestic income via improved net exports. Therefore, the correct answer to the original question is option C: domestic interest rate will increase, domestic national income will increase.

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