Now that we have reviewed the impact and steady-state effects of various disturbances, we are ready to show how the economy travels from the one to the other and how its behavior over time is affected by the exchange-rate regime. We shall not do so however, for all of the disturbances studied in Chapters 4 and 5. Instead, we shall select examples that illustrate clearly the processes at work under the two exchange-rate regimes.

Comparative-static analysis has already revealed strong generic similarities between adjustments to the principal disturbances under a given exchange-rate regime, and it is one purpose of this chapter to stress those similarities. With a pegged exchange rate, for example, goods-market disturbances have permanent effects on income, and asset-market disturbances do not. With a flexible exchange rate, the pattern of outcomes is usually reversed. Therefore, we look first at dynamic responses to the principal disturbances under a pegged-rate regime, then at responses to the same disturbances under a flexible-rate regime.

To show how the economy behaves with a pegged exchange rate, we study two disturbances–a shift of demand between traded goods and an open-market operation in the domestic bond. We also study the responses to a devaluation. Thereafter, we examine the dynamics of adjustment under a flexible exchange rate, studying the same pair of disturbances. Finally, we consider the responses to a tax cut, the disturbance that produces the most complex reactions under both regimes, because it involves a budget deficit.