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Q. Use the DD - AA model to examine and compare the response of an economy under fixed and floating exchange-rate regimes to a temporary fall in foreign demand for its exports.
Answer: The DD curve moves to the left. When the exchange rate floats for the reason that the demand shift is assumed to be temporary it doesn't change the long-run expected exchange rate and thus does not move the asset market equilibrium schedule AA. Therefore, E goes up that is the currency depreciates and output falls.
In a fixed exchange rate policy the central bank should prevent the currency depreciation that occurs under a floating rate therefore it buys domestic money with foreign currency dropping the domestic money supply and shifting the AA to the left and down. E will stay remain constant and output will fall.
Q. Explain why under fixed exchange rate, monetary policy is ineffective whereas under floating exchange rate it is effective in rising output. Answer: In floating by purchasi
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