The exchange rate as an automatic stabilizer
Consider an economy that suffers a fall in business confidence (which tends to reduce investment). Let UIP stand for the uncovered interest parity condition.
a. Suppose the economy has a flexible exchange rate. In an IS-LM-UIP diagram, show the short-run effect of the fall in business confidence on output, the interest rate, and the exchange rate. How does the change in the exchange rate, by itself, tend to affect output? Does the change in the exchange rate dampen (make smaller) or amplify (make larger) the effect of the fall in business confidence on output?
b. Suppose instead the economy has a fixed exchange rate. In an IS-LM-UIP diagram, show how the economy responds to the fall in business confidence. What must happen to the money supply in order to maintain the fixed exchange rate? How does the effect on output in this economy, with fixed exchange rates, compare to the effect you found for the economy in part (a), with flexible exchange rates?
c. Explain how the exchange rate acts as an automatic stabilizer in an economy with flexible exchange rates.