Suppose output is above the natural level of output. In a fixed exchange rate regime, explain the two ways the economy can return to the natural level of output.

What will be an ideal response?

ANSWER:

Revaluation. Policy makers could revalue the currency. This would cause a reduction in NX, and reduction in demand, and a reduction in Y. Graphically, the AD curve would shift to the left. Economy self-corrects. With Y above the natural level, the expected price level (or expected inflation) will rise causing W to rise. As W rises, P will rise. As P rises, a real appreciation occurs and NX falls. We would move along the AD curve.