Q. Under fixed exchange rate, show using a figure, the effects of an expansionary fiscal policy. Show the equilibrium under a flexible exchange rate. Discuss the difference in the two regimes.

Answer: An expansionary monetary policy shifts the DD curve to the right. In flexible exchange rate point 2 in the figure is the balance e decreases (appreciates) and Y goes up. The picture is more complex under fixed exchange rate though since E can't change. Output is going up as a result of the financial expansion and therefore the demand for domestic money increases.

To prevent the enlarged money demand from increase domestic interest rate above R* and with the appreciation of the currency the central bank must buy foreign assets with domestic money and thus increase the money supply. The AA shifts near the right until E is restored to the initial fixed exchange rate E⁰ at point 3 in the figure.

Thus under fixed exchange rate Y will enhance by more than under a flexible exchange rate regime. Dissimilar monetary policy fiscal policy is able to be used to affect output under a fixed exchange rate. A central bank is obligatory to expand the money supply through foreign exchange purchases.