When the exchange rate, E, and the foreign price level, P*, is fixed, domestic inflation depends primarily on
A) amount of aggregate demand.
B) home price level set by IMF.
C) current account balance.
D) government tax policy.
E) foreign interest rates.

Question

Quizplus · Accepted Answer

When the exchange rate and foreign price level are fixed, any change in domestic inflation is a result of changes in the amount of aggregate demand within the economy. If aggregate demand exceeds the economy's capacity to produce goods and services, then there will be upward pressure on prices, leading to inflation. Conversely, if aggregate demand is lower than the production capacity, then there will be downward pressure on prices, leading to deflation.

When the Exchange Rate, E, and the Foreign Price Level