If the country is on a fixed exchange rate system however, the central bank as we discussed earlier will intervene into the foreign exchange market to buy or sell foreign currency depending on the BOP position the country is in.
When there is an excess demand for foreign currency (BOP deficit), the central bank intervenes by selling foreign currency in exchange for domestic currency. This reduces the amount of domestic currency in circulation causing money supply in the country to decline and the LM curve therefore shifts left.
On the other hand, an excess supply of foreign currency (BOP surplus) means that the central bank will now buy foreign currency in exchange for domestic currency. As the amount of domestic currency in circulation increases, money supply in the country increases resulting in the LM curve shifting to the right.
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