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?



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.