Question

1. A country operates under a flexible exchange rate system. When the central bank lowers the interest rate during a recession, how does this affect investment and net exports, and ultimately aggregate demand? What if the exchange rate was fixed instead?

Answer 1

In the case of flexible exchange rate system, the exchange rate depends on the supply and demand of the currency in the market. When the central bank lowers the interest rate during a recession, there would be more currency floating in the market. Thus the supply of currency increases in the market. As a result the exchange rate dips due to excessive supply. This would overall increase the investment and net exports as the outside players are able to get the deal done at a reasonable rate. Ultimately the aggregate demand would also rise because of more money available to the consumers.

If the exchange rate was fixed, there wont be any change in the exchange rate. Thus would not affect the investment and net exports. The aggregate demand would definitely rise due to availability of more cash floating in the market.