Symmetric versus asymmetric shocks and the need for (real) exchange rate flexibility
1. Explain why a low and stable domestic inflation rate under fixed exchange rates requires a stable real exchange rate as woll as a low and stable inflation rate in the foreign anchor country.
2. Explain the difference between symmetric and asymmetric shocks in open economies. Illustrate the effect on the long-run equilibrium exchange rate of a permanent positive supply shock when the shock is asymmetric and compare with the effect of a symmetric shock. Explain why a fixed nominal exchange rate may be problematic in the scenario with an asymmetric shock.
3. Discuss the potential role of fiscal policy in a country with fixed exchange rates exposed to asymmetric shocks.
4. Assume that a group of countries with fixed but adjustable exchange rates and strong international trade links are exposed to a symmetric negative demand shock. What would happen if all (or most) countries tried to escape from the resulting recession by devaluing their currencles? What would be the most rational economic policy response from an international perspective?