Question

In a fixed exchange rate regime, an increase in the price level will cause which of the following? Explanation please

A) a real appreciation and a leftward shift in the aggregate demand curve

B) a real appreciation and no shift in the aggregate demand curve

C) a real depreciation and a rightward shift in the aggregate demand curve

D) a real depreciation and no shift in the aggregate demand curve

E) no change in the real exchange rate, and no change in aggregate demand

Answer 1

A) a real appreciation and a leftward shift in the aggregate demand curve.

Real exchange rate = eP/P*

where is P is domestic price level.

P* is the foreign price level.

e is the nominal exchange rate. It is the amount of foreign currency that can be traded with one unit of domestic currency.

Real exchange rate the number of foreign goods that can be traded with one unit of domestic good.

It is given that fixed exchange rate regime. So, nominal exchange rate can't change. e is fixed.

It is also given that the price level has increased. [We are assuming it is the domestic price]. So real exchange rate increases.

It means more number of foreign goods can be traded than before with the same number of domestic goods. Conversely, less number of domestic goods can be traded with one foreign good. So, the real exchange rate appreciates.

Due to this appreciation of real exchange rate, now domestic residents will buy more foreign goods than before and foreign residents will buy less domestic goods. This leads to increase in imports and decrease in exports for domestic country. This leads to a fall in Net exports (NX).

Since the net exports have fallen, the Aggregate demand (AD) curve will shift leftwards.

Therefore, the answer is A.