First, briefly explain why the AD curve is downward sloping in a closed economy. Second, briefly explain why the AD curve is downward sloping in an open economy under fixed exchange rates. And finally, briefly compare the size of the slopes of the two AD curves.

What will be an ideal response?

ANSWER:

In a closed economy, P affects Y via its effects on M/P, i, and I. In fixed exchange rate regime, changes in P will affect M/P; however, the domestic interest rate cannot change. So, P now affects Y via its effects on the real exchange rate. A drop in P causes a real depreciation, an increase in NX, and an increase in Y. Because the change in P has a second effect in the open economy version, that would tend to make the AD curve steeper in the open economy under fixed exchange rates. However, recall that the multiplier will be smaller in an open economy because of the marginal propensity to import. This would have an offsetting effect.