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.