ABSTRACT
Under fixed exchange rates, the central bank stands ready to buy or sell foreign exchange when the balance of payments is in surplus or deficit. The equilibrium occurs at the intersection of the investment/saving (IS), liquidity-money (LM), and balance of payments (BP) curves. It is easy to determine how a particular policy change affects net exports and workout the effects of monetary, fiscal, and exchange rate policy under a variety of assumptions about the degree of capital mobility, which reflects in the slope of the BP curve. Sterilization is able to work when the central bank can lower the interest rate. Devaluation raises the level of Gross Domestic Product (GDP) remains valid for any degree of capital mobility. Under zero mobility, devaluation may be the only way to permanently increase GDP, without resorting to the temporary expedient of sterilization, since the economy is strictly constrained by balance of payments considerations.
