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Q. Using a figure illustrate the simultaneous equilibrium of the foreign exchange and domestic money markets when the exchange rate is fixed at E0 and is expected to remain fixed at E0 in the future. Assume both P and Y is constants. Now, study the effect of an increase in income, Y.
Answer: The L(R*, Y) will shift down as well as to the right, which will require an increase in M to M2. This will necessitate the domestic central bank to purchase foreign assets and thereby increase the money supply leaving E at E0. Note that R = R* at the new balance as before.
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