Question

The diagram below shows the effect of a monetary expansion in an open economy with a fixed exchange rate. Complete the diagram to show the secondary effect and explain how that secondary effect occurs. (The verbal description should indicate what variables are affected by the primary effect in order to induce the secondary effect.)

Price Index ASO 100 AD1 ADo Real GDP Yo A

Answer 1

AS 100 ADo ADI Real GDP Yo If a country is following fixed exchange rate, the central bank loses control over the money supply. In case of monetary expansion, the aggregate demand will increase (shift rightwards from ADo to AD1) in short run leading to higher real GDP [primary effect]. Note that the prices do not change in the short run (price index in figure is 100 for both the equilibrium points). However, higher aggregate demand will also lead to lowering of the exchange rate [secondary effect]. Since the central bank is committed to a fixed exchange rate, it will respond to the lowering of exchange rate by buying the domestic currency from the market. It will reverse the shift of aggregate demand curve to its previous level. Thus, the monetary policy renders ineffective under the fixed exchange rate. Price Index