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Q. Use the fixed exchange rate DD - AA model to describe the economy's short-run equilibrium. Then, use the same figure to study an expansionary monetary policy. Show that the policy is ineffective.
Answer: The fixed exchange rate DD - AA model necessitates the assumption that E = E0 this illustrate that the economy's short-run equilibrium is at point 1 when the central bank fixes the exchange rate at the level C. Output equals Y1 at point 1 as well as the money supply is at the level where a domestic interest rate equal to the foreign rate (R*) clears the domestic market.
To Increase Output: Eager to increase output to Y2 the central bank increases the money supply throughout the purchase of domestic assets and shifting AA1 to AA2. For the reason that the exchange rate is fixed the central bank must maintain E0 it has to sell foreign assets for domestic currency thus decreasing the money supply immediately and returning AA2 back to AA1. Output is unaffected as the initial equilibrium is maintained.
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