Q. Use a figure to study the following question: Consider that the economy is at a point on the DD-AA schedule that is above both AA and DD, where both the asset and output markets are out of equilibrium. Explain what will happen next.

Answer: Because the asset market adjusts extremely quickly the exchange rate drops immediately to a point on the AA schedule. There will be surplus demand for the domestic currency for the reason that the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This surplus demand leads to an immediate fall in the exchange rate.