Question

1. The US corporate sector cuts spending sharply due to expectations of low future sales and tight financial conditions. Use (appropriate variants of) the DD–AA diagram to study the following scenarios related to this shock, in terms of US real activity (GDP) and the nominal exchange rate.

   (a) How would the consequences of this shock differ if the US would operate under a fixed exchange rate regime (a “peg”) as opposed to a flexible exchange rate (“float”)? (For all following questions assume that the US is under a flexible exchange rate regime.)

Answer 1

1. US corporate sector cuts spending then it is said to be reduction in investment. Change in investment will affect DD curve this can be shown with the help of diagram:

Initial equilibrium is at point E. Decrease in investment leads to leftward shift of DD curve to D'D'.

This leads to rise in nominal exchange rate and fall in GDP.

2. If country would have fixed exchange rate, the central bank would not allow to rise the exchange rate as it is fixed, it will sell the domestic currency in the forex market to reduce the value of domestic currency so that nominal exchange rate which was higher falls down and comes back to original position to E in the graph.