1. only when the exchange rate is fixed.
2. regardless of whether the exchange rate is fixed or flexible provided that there is full employment.
3. only when the exchange rate is flexible.
4. in none of the above cases.
Choose the correct option.
The correct choice is option 1. When the exchange rate is flexible, the nominal money supply is determined exogenously by the government. This sets the level of the LM curve at each level of prices. When the exchange rate is fixed, equilibrium is determined by the intersection of the IS curve and the world interest rate line and the money supply and level of the LM curve are endogenous. If domestic residents have a different money stock than they wish to hold, portfolio pressures will force the exchange rate off its peg unless the central bank appropriately adjusts the money supply by purchasing and selling foreign exchange reserves in return for domestic currency.
If there is both exchange rate and price flexibility, the price level will adjust to ensure that LM crosses the world real interest rate line at YFYF , so the real money supply will be endogenous even though the nominal money supply is not. When there is price flexibility and fixed exchange rates, the real exchange rate will adjust to ensure that IS crosses the world interest rate line at YFYF , but this does not eliminate the endogeneity of the money supply and LM curve in that case.
It should also be noted that the central bank can choose to adjust the nominal money supply to maintain the fixed exchange rate by purchases and sales of domestic bonds in lieu of foreign exchange reserves.