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. As we have seen, this automatically ties the money supply to the balance of payments, unless the central bank chooses to sterilize. A balance of payments surplus implies that the central bank is buying an equivalent amount of foreign exchange, which raises the nation's money supply accordingly, while a balance of payments deficit reduces the money supply. Thus, under fixed exchange rates, balance of payments equilibrium is achieved through shifts in the LM curve.
