Q. Suppose E is fixed at E⁰ and that the asset markets are in equilibrium. Suddenly output rises. What monetary measures keep the current exchange rate constant given unchanged expectations about the future rate?

 Answer:

• Since output rise demand for domestic money raises this raise in money demand usually pushes the domestic interest rate upwards. To avoid appreciation of home currency given E0 is predictable the central bank buys foreign assets in foreign exchange market.

• This eliminates surplus demand for domestic money because the central bank issues money to pay for the foreign assets it buys.

• The bank raises the money supply in this way until asset markets clear with E = E0 and R = R*.