Question

With a flexible exchange rate and free capital mobility, monetary policy will be:

A) Is completely ineffective in changing the level of output

B) Is very effective in changing the level of output

C) Is completely ineffective in changing the level of output, but effective in changing domestic interest rates

D) Is very effective in changing the level of output and domestic interest rates

E) Cannot be conducted independently of exchange rate considerations

Answer 1

With a flexible exchange rate and free capital mobility, monetary policy will be

B) Is very effective in changing the level of output

Explanation: in a world of flexible exchange rate and prefect capital mobility, assumes that interest rate (i) = interest rate abroad (iF), i.e. i = iF, So B P (balance of payment) curve will be horizontal. Any monetary policy will not shift interest rate, but will affect output.

In the figure is the case of monetary policy expansion. The new equilibrium will be at A" With output at Y2.