Consider an economy that operates with a FIXED exchange rate ( E 0 ). The economy is

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Question:

Consider an economy that operates with a FIXED exchange rate (E⁰). The economy is initially in equilibrium at point 1 in the diagram below where equilibrium output/national income is Y¹.

The government of this economy is faced with a problem: the country is running an excessively large current account surplus with the result that those foreign countries which are its main trading partners are threatening to retaliate by imposing trade restrictions against its exports. The government decides to eliminate this problem through a change in the official exchange rate from its current value of E⁰ to a new level of E¹_.

a) To solve the problem of an excessive current account surplus the government of this economy should engage in a currency _______________ (devaluation/revaluation) by _______________(increasing/decreasing) the official exchange rate. The result will be a shift of the ________(DD/AA) curve of the economy to the __________ (right/left).

b) How and why will equilibrium output (Y) change as a result of the change in the official exchange rate you have described in answer to part a)? Explain.

c) The change in the level of output/national income (Y) which you describe in part b) above will lead to a ______________(increase/decrease) in real money demand (M^d/P) causing the domestic interest rate (R) to _______________(fall below/rise above) the foreign interest rate (R*) and creating pressure on the exchange rate (E) to __________________(fall below/rise above) its new official value of E¹. To maintain the exchange rate fixed at its new value of E¹ the domestic central bank must intervene in the FX market to ________________(buy /sell) ________________(domestic/foreign) currency, thus _______________(increasing/decreasing) the domestic real money supply (M^S/P) leading to a money market equilibrium in which the domestic and foreign interest rates are equal (R=R*) and FX market equilibrium at an exchange rate of E¹.