And adopt a new xed exchange rate e1 that is higher

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and adopt a new °xed exchange rate, E1, that is higher than the current rate, E0. THE UPPER PART: a change in expectations as a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits (this is the only e/ect under ±exible exchange rates). To hold the exchange rate °xed at E0 after the market decides it will be devalued to E1, the central bank must use its reserves to °nance a private capital out±ow that shrinks the money supply and raises the home interest rate
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4. [20 points] A temporary tax cut shifts the DD curve to the right and, in the absence of monetization, has no e/ect on the AA curve. In °gure (2), this is depicted as a shift in the DD curve to D²D² , with the equilibrium moving from point 0 to point 1. If the de°cit is °nanced by future monetization, the resulting expected long-run nominal depreciation of the currency causes the AA curve to shift to the right to A²A²which gives us the equilibrium point 2. The net e/ect on the exchange rate is ambiguous, but output certainly increases more than in the case of a pure °scal shift. SPECULATIVE ATTACK

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