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Answer to Question #71203 in Macroeconomics for Ramintha Bitnarajah

Question #71203
Use the small open economy IS-TR-IFM model, and the example of an
exogenous increase in business confidence (i.e. an increase in Tobin’s q), to
a) Explain how a flexible exchange rate regime provides insurance against
demand shocks. [15]
b) Describe how the composition of output changes in response to the demand
shock, even as total output does not. [10]
Expert's answer
a) A flexible exchange rate is a regime where the currency price is set by the forex market based on supply and demand compared with other currencies.
b) A demand shock is a sudden surprise event that temporarily increases or decreases demand for goods or services. A positive demand shock increases demand, while a negative demand shock decreases demand.

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