arborland is a small open economy with a floating exchange rate. it's local currency is arbor dollars. then, the central bank increases the money supply. a. using the mundell fleming 3-panel diagram, illustrate what happens in each panel. for all graphs, label the initial equilibrium as point a, the final equilibrium as point b. b. when the central bank increases the money supply, determine if there is initially upward or downward pressure on interest rates and provide economic intuition. also determine whether exchange rates increase or decrease, and provide economic intuition.

(a) Money supply expansion causes the LM curve to move right, lowering domestic interest rates. Net capital outflow, which is inversely connected to domestic interest rate, rises as domestic interest rate declines.

Since net capital outflow and net exports are equivalent, an increase in net capital outflow leads to an increase in net exports, which lowers the exchange rate (causing the local currency to depreciate).

Panel A of the accompanying graph displays the IS and LM curves. Initial interest rate r0 and initial output Y0 are located at point A, where initial IS and LM curves cross.

LM0 shifts to LM1 to the right as money supply rises, crossing IS0 at point B with a lower interest rate r1 and greater output Y1. As money supply increases, LM0 shifts right to LM1, intersecting IS0 at point B with lower interest rate r1 and higher output Y1.

A lower interest rate from r0 to r1 raises net capital outflow from NCO0 to NC01 in panel B (which shows net capital outflow as an inverse function of interest rate).

An increase in net capital outflow from NCO0 to NCO1 raises net exports from NX0 to NX1 and reduces exchange rate from e0 to e1 in panel C (which shows net exports as an inverse function of exchange rate).

B) The amount of reserves available for lending grows together with the money supply, which lowers interest rates.

Domestic currency demand declines as a result of falling domestic interest rates and falling foreign investment in the nation. As a result, the value of native currency drops, lowering the exchange rate.

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