Question

A country that has been operating under a fixed exchange-rate regime falls into recession. All attempts at using fiscal polecat to lift the economy out of recession have failed.

1. If the central bank was to use monetary policy to help lift the economy out of the recession, it would want to (change, decrease or increase) the money supply and (changes decrease or increase) interest rates in the economy.

2. This change in interest rates would cause net capital outflow to (increase, remind unchanged or decrease). The value of the domestic currency would (remain unchanged, decrease or increase)

3. To maintain the fixed exchange rate, the central bank would have to (buy or sell) domestic currency

4. Under a fixed exchange-rate regime, the central bank (cannot or can) use monetary policy to influence economic activity.

5. Should the country allow the exchange rate to float?

a. Both of these answers are correct

b. No if the main goal is to maintain the fixed exchange rate

c. yes if the main goal is to lift the economy out of recession

Answer 1

1. If the central government were to use monetary policy to lift the economy out of recession, it would increase money supply and decrease interest rates in the economy.

2. The decrease in interest rates would cause capital outflow to increase. The value of domestic currency would decrease due increased supply of domestic currency.

3. To maintain fixed exchange rate, the central bank would have to buy domestic currency to reduce its supply.

4. Under fixed exchange rate, the central bank cannot use monetary policy to influence economic activity.

5. The correct option is a.