Q. "Under floating rates, the economy is more vulnerable to shocks coming from the domestic money market." Discuss.

Answer: It is true statement, under floating rates an increase in real domestic money demand causes income to fall and domestic currency to appreciate. If the increase in real domestic money supply is permanent it will lead ultimately to a fall in the home price level.

Under a fixed exchange rate the variation in real money demand doesn't affect the economy at all. To protect the home currency from appreciating the central bank buys foreign reserves with domestic money until the real money supply go up by an amount equal to the rise in real money demand. This intervention has the consequence of preventing any change in output or the price level.