Discuss the difference in the two regimes.

Under fixed exchange rate, show using a figure, the effects of an expansionary fiscal policy. Show the equilibrium under a flexible exchange rate. Discuss the difference in  the two

Answer: An expansionary fiscal policy shifts the DD curve to the right. Under flexible exchange rate, point 2 in the figure is the equilibrium, e decreases (appreciates) and Y goes up. The picture is more complicated under fixed exchange rate, however, since E cannot change. Output is going up as a result of the fiscal expansion, and thus the demand for domestic money increases. To prevent the increased money demand from increase domestic interest rate above R*, and with the appreciation of the currency, the central bank must buy foreign assets with domestic money and thereby increase the money supply. The AA shifts to the right until E is restored to the initial fixed exchange rate, E⁰, at point 3 in the figure.

So under fixed exchanger rate, Y will increase by more than under a flexible exchange rate regime. Unlike monetary policy, fiscal policy can be used to affect output under a fixed exchange rate. A central bank is forced to expand the money supply through foreign exchange purchases.