use the same figure to study an expansionary monetary policy.

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

Answer: The fixed exchange rate DD – AA model requires the assumption that

E = E⁰ . This shows 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 and 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: Hoping to increase output to Y², the central bank increases the money supply through the purchase of domestic assets and shifting AA¹ to AA². Because the exchange rate is fixed, the central bank must maintain E⁰, it has to sell foreign assets for domestic currency, thereby decreasing the money supply immediately and returning AA² back to AA¹.

Output is unchanged as the initial equilibrium is maintained.