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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.
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