1. shifts both IS and LM to the right.
2. has no effect on the LM curve.
3. shifts IS to the right and LM to the left.
4. shifts IS to the right and leaves LM unchanged.
Choose the option above that is correct.
Option 2 is the correct one. A rise in the real exchange rate leads to a switch of world (including domestic) expenditure from domestic to rest-of-world goods, shifting the IS curve to the left. This rise in the real exchange rate has no effect on the LM curve because that curve, since it deals exclusively with asset equilibrium, is defined independently of equilibrium in the markets for real goods.
This can be seen from looking at Equations 1a and 2, the respective equations of the LM and IS curves:
1a. r = − (1/θ) M/P + γ/θ − τ + (ε/θ) Y
2. Y = ( a + δ + ΦBT + DSB)/(s + m) − μ/(s + m) r + m* /(s + m) Y* − σ/(s + m) Q
Note that the variable Q appears in Equation 2, the IS equation, with a negative sign but does not appear at all in Equation 1, the equation of the LM curve.