Determine the term - Fixed Exchange Rates

With a fixed exchange rate adjustment toward long run equilibrium occurs via monetary effects. This effect is shown in Figure 9.1. At point B country A is running a balance of payments deficit. In order to stop its exchange rate from depreciating the monetary authorities in that country must buy its domestic currency and sell foreign exchange. This will reduce the amount of high power money in that economy and cause a multiple contraction in the domestic money supply. This is shown by a leftward shift of the LM curve. In country B this process is reversed causing its domestic money supply to increase and its LM curve to shift to the right. These adjustments continue until both economies return to long run equilibrium at point C. At this point both countries experience balance of payments equilibrium, and their domestic rates of interest equal the world rate of interest. With balance of payments equilibrium neither country need intervene any further in foreign exchange markets and so each country's domestic money supply remains unchanged.