Q. Using the AA - DD framework, compare the effects of a rise in real domestic money demand under flexible and under fixed exchange-rate regimes.
Answer: Under floating an increase in real domestic money demand shifts the AA curve down and leftward, income falls and E reduce that is the domestic currency appreciates. If the increase in real domestic money supply is permanent it will initiates eventually to a fall in the home price level. In a fixed exchange rate the amend in real money demand doesn't affect the economy at all. The AA curve does not move. To avoid the home currency from appreciating the central bank buys foreign reserves with domestic money until the real money supply increases by an amount equal to the increase in real money demand. This intervention has the result of keeping the AA in its original position preventing any alteration in output. This is a powerful argument in favour of fixed rates if the majority of the shocks that buffet the economy come from the home money market.