Answer to Question 1
The world economy can affect aggregate demand through the foreign exchange rate and foreign income. If the foreign exchange rate falls, then U.S. aggregate demand increases because U.S. exports become cheaper to foreign residents while U.S. imports become more expensive to U.S. citizens. If foreign income increases, then U.S. aggregate demand increases because foreign citizens will spend some of their increased income on U.S.-produced goods and services.
Answer to Question 2
The deep factors that change exchange rate expectations are purchasing power parity and interest rate parity. Purchasing power parity is the proposition that money buys the same amount of goods and services in different currencies differences. If purchasing power parity does not prevail, in the long run the exchange rate changes so that it holds. People realize this change will occur and so it factors into their expectations of the exchange rate. Interest rate parity is the proposition that the interest rate in one currency equals the interest rate in another currency when exchange rate changes are taken into account. If interest rate parity does not prevail, the exchange rate changes immediately so that it holds. People realize that interest rate parity always prevails so it factors into their expectations of the exchange rate.
Before the stick is broken, it must first be bent (the transition state).
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