There are two ways to adjust the level cap: by entering a new level cap manually in the "Game Rules" section of your class settings or by letting the game calculate it for you using the "Game Duration" option (also available in the "Game Rules").
Either way, the changes made to the level cap will affect your students' XP. Automatically, the game will adjust the amount of XP earned by students so that it remains proportional to their current level. If a student had accumulated 500 XP with a 1000 XP level cap, their points would rise to 1000 XP when their level cap was upped to 2000 XP. In other words, the student's progression would remain at half of their current level, just as it had been previously.
Effectively, all students remain at the same level, but the amount of XP they have changes. If changing the level cap changed students' levels, they'd experience disruptions like loss of gear, Power Points, GP earned through leveling, etc.