Question

Suppose only the foreign country is suffering from the corona virus pandemic.

Using the DD – AA framework, analyze the effects of this shock on the balance of payment and the output.

a) under the fixed exchange rate system

Answer 1

Under a fixed exchange rate system, a negative demand shock caused by a pandemic in a foreign country would lead to a decrease in imports and an improvement in the balance of payments. It would also result in a decrease in output as businesses reduce production.

Step-by-step explanation:

Under a fixed exchange rate system, the exchange rate between the domestic currency and the foreign currency is fixed and does not change. In this scenario, if only the foreign country is suffering from the COVID-19 pandemic, it would be considered a negative demand shock. This shock would lead to a decrease in imports from the foreign country, which would improve the balance of payments as the country's imports would decrease. Additionally, the decrease in imports would lead to a decrease in output as businesses reduce their production in response to lower demand for imported goods.