Use a diagram to illustrate a foreign exchange market for a country with a fixed exchange rate, er*, initially in balance of payments equilibrium. Suppose this country experiences a substantial increase in demand for its exports that results in a balance of payments surplus. Illustrate and explain the effects of this export shock on the foreign exchange market. What action must the central bank take to defend the fixed exchange rate? What are the consequences for the domestic economy?

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The Answer of Use a diagram to illustrate a foreign exchange market for a country with a fixed exchange rate, er*, initially in balance of payments equilibrium. Suppose this country experiences a substantial increase in demand for its exports that results in a balance of payments surplus. Illustrate and explain the effects of this export shock on the foreign exchange market. What action must the central bank take to defend the fixed exchange rate? What are the consequences for the domestic economy?

Use a Diagram to Illustrate a Foreign Exchange Market for a Country