Answer to Question 3:

When the small country fixes the exchange rate it insulates itself from foreign real shocks but not from domestic real shocks.

True or False?


The statement is false. When the exchange rate is fixed, equilibrium in the small country depends on the intersection of its  IS  curve with the real interest rate line. A change in the world interest rate will thus necessarily involve a change in the small country's output, since the  IS  curve is negatively sloped. So insulation from foreign real shocks does not occur. A real shock in the small country shifts its  IS  curve. Since equilibrium is determined by the intersection of  IS  and the real interest rate line a real shock in the small country must lead to a change in its output and ultimately its price level. So a fixed exchange rate does not insulate a small open economy from domestic real shocks either.

There is a possibility that fixing the exchange rate may insulate the small country's price level from big-country real shocks in the long run. If the equilibrating change in the price level in the big country happens to move the small country's real exchange by just the right amount, the small country's price level could end up unchanged (along with, of course, the nominal exchange rate) in the new equilibrium compared to the pre-shock situation. This can be seen from the definition of the real exchange rate.

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