Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level of output. Now suppose that households as a result of an increase in consumer confidence increase consumption. Given this information, we know that:
A) the real exchange rate only increases in the medium run if foreign prices fall.
B) the real exchange rate will be permanently lower in the medium run.
C) the real exchange rate will be unchanged in the medium run.
D) the real exchange rate will be permanently higher in the medium run.
E) the effects of this consumption increase on the real exchange rate will be ambiguous in the medium run.

Question

Quizplus · Accepted Answer

In the medium run, the increase in consumption will lead to an increase in aggregate demand, which will put upward pressure on the price level. This will cause the real exchange rate to appreciate, making domestic goods more expensive relative to foreign goods.

Assume That Policy Makers Are Pursuing a Fixed Exchange Rate