A country has a fixed exchange rate. Initially, the country has a surplus in its overall international payments, as well as excessive aggregate demand that is putting upward pressure on the country’s price level because the current level of real GDP (Y0) is greater than the “full-employment” level of real GDP (Yfull). The country’s international capital flows are noticeably responsive to changes in interest rates (the country’s FE curve is upward sloping and flatter than its LM curve). Evaluate the ability of each of the following policies (separately, not in combination) to address the initial macroeconomic situation.

In each answer, use an IS–LM–FE graph as part of the explanation.

a. Sterilized intervention to defend the fixed exchange rate.

b. A change in the fixed-rate value of the country’s currency.