The figure is the familiar AS/AD model you′ve used many times earlier. However, this is the open economy version. This means that changes in the exchange rate and in foreign income affect aggregate demand. We can look at this from the perspective of depreciation and from appreciation:

• Because a depreciation of the exchange rate and an increase in foreign income together increase net exports, they both cause the AD curve to shift to the right.

• Because an appreciation of the exchange rate and a decrease in foreign income together decrease net exports, they both cause the AD curve to shift to the left.

In this example, exchange rates are fixed. The exchange rate will only appreciate or depreciate if the government decides to change its value. (Look at the active graph The effects of fiscal expansion under fixed exchange rates to see how this works.)

1. Is the economy in a recession or an expansion ?
2. If the government does nothing to fiscal policy, nothing to monetary policy, or nothing to exchange rate policy, what will happen to output and the price level ?
3. What type of fiscal policy could raise output up to potential output ?
4. Suppose instead, the government thought the fixed exchange rate is incorrect – that is, the fixed exchange rate does not equal the value implied by the relative price level and economic activity of the domestic country. Should the government devalue its currency – that is, do something to cause a depreciation in the value of its currency relative to the value of the currency of another country or countries ?
5. What is the effect of a devaluation on output and the price level ?