Question

How can a country increase output in the short run and maintain a fixed exchange rate in the same time, using monetary policies?

Answer 1

Using only monetary policy, the country cannot increase its output under a fixed exchange rate regime. This is because when monetary expansion is used to increase the aggregate demand and the resultant real output, there is an exchange rate depreciation which is against the commitment of fixed exchange rate. To maintain the rate of exchange at the committed level, the currency depreciation has to be reversed which is done by decreasing the money supply. It is due to this reason that monetary policy is not helpful in raising the output level in fixed exchange rate regime

To increase output in fixed exchange rate regime, a monetary policy should be used in combination with fiscal policy. Both monetary expansion and fiscal expansion are required to increase the real GDP. When monetary expansion brings currency depreciation, fiscal expansion will increase the rate of interest and cause the currency to appreciate, thereby negating the previous depreciation as well as racing the level of output. Hence, both monetary and fiscal expansion are required to increase GDP