Refer to the above figure. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a permanent fall in foreign demand for its exports

Question

What will be an ideal response?

Answer 1

The DD curve shifts to the left. Under flexible exchange rate, the expected exchange rate Ee also rises and AA shifts upward and to the right. Thus, a permanent shock causes a greater depreciation than a temporary one.
Under fixed exchange rate, the central bank must prevent the currency depreciation that occurs under a floating rate; thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall.
Under fixed exchange rate, a fall in export demand if permanent have led to a situation of "fundamental disequilibrium" calling for a devaluation of the currency or a long period of domestic unemployment as export prices fell. Uncertainty about the government's intention would have encouraged speculative capital outflows, further worsening the situation by depleting central bank reserves and contracting the domestic money supply at a time of unemployment.