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Q. Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD and where both the output and asset markets are out of equilibrium. Explain what will happen next.
Answer: Since the asset market adjusts extremely quickly the exchange rate drops immediately to a point on the AA schedule and there will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This surplus demand escorts to an immediate fall in the exchange rate.
Q. If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at E 0 ? An
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Q. Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD and where both the output and asset markets are out of equilibrium. Explain what will h
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