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Use the DD-AA model to examine the effects of a one-time rise in the foreign price level

1. Use the DD-AA model to examine the effects of a one-time rise in the foreign price level, P*. If the expected future exchange rate rises immediately in proportion to P* (in line with PPP), show that the exchange rate will also appreciate immediately in proportion to the rise in P*. If the economy is initially in internal and external balance, will its position be disturbed by such a rise in P*?
2. If foreign inflation rates rise permanently, do you expect floating exchange rates to insulate the Canadian economy in the short-run? How about the long-run? Why?
3. How would you analyze the use of monetary and fiscal policy to maintain internal and external balance under a floating exchange rate?
4. Under what type of exchange rate system, fixed or floating, is there a larger output effect arising from a transitory increase in the foreign interest rate, R*? Does your answer change if the increase in R* is permanent? Does it matter if this increase is due to a rise in foreign real interest rates or a rise in foreign inflation expectations (the Fischer effect)?

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Under what type of exchange rate system, fixed or floating, is there a larger output effect arising from a transitory increase in the foreign interest rate, R*?

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