If the central bank does not purchase foreign assets when output incre

If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at ? Please explain.

What will be an ideal response?

ANSWER

No, the rise in output leads to an excess demand for money. If the central bank does not increase supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This higher rate of return (and given expectations in the foreign exchange market) would cause the exchange rate to fall below .