The exchange rate as an automatic stabilizer Consider an economy that suffers a fall in business confidence (which tends to lower investment).

a. Suppose that the economy has a flexible exchange rate. In an IS-LM-IP diagram, show the short-run effect of the fall in business confidence on output, the interest rate and the exchange rate. How does the change in the exchange rate, by itself, tend to affect output? Does the change in the exchange rate dampen (make smaller) or amplify (make larger) the effect of the fall in business confidence on output? (4 marks)

b. Suppose instead that the economy has a fixed exchange rate. In an IS-LM-IP diagram, show how the economy responds to the fall in business confidence. What must happen to the money supply in order to maintain the fixed exchange rate? How does the effect on output in this economy with fixed exchange rates compare with the effect you found for the economy in part (a), which had flexible exchange rates? (4 marks)

c. Explain how the exchange rate acts as an automatic stabilizer in an economy with flexible exchange rates. (2 marks)