Question

1. Why is it often said that monetary policy is powerless as a tool of stabilization policy under fixed exchange rates

Answer 1

Ans

Because it is quite ineffective particularly when there is perfect capital mobility. E. G suppose that to counter recession central bank increases money supply. This shifts LM curve rightwards. Interest rate falls and national income rises This leads to capital outflow. Also lower interest rate leads to less demand for currency. Higher national income leads to greater demand for imports. Because of capital outflow and greater imports domestic currency depreciates. To counter it central bank sell foreign exchange reserves This contracts money supply until LM shifts back towards initial situation