Chapter 8) Suppose country A pegs its currency to country B (i.e., country B is the...

Chapter 8) Suppose country A pegs its currency to country B (i.e., country B is the center country). Suppose country A is in recession. To help country A, what does the country B’s Central Bank can do? As a result, what happens to IS and LM curves in both countries? (Use graphs to explain)

Expert Solution

Consider the given problem here there are two country “A” and “B” both of them is in equilibrium at Ea and Eb respectively.

Now, to increase the level of output of countryA, country can take expentionary monetary policy. So, the LM of country B will shift to right side to LMb2 and the equilibrium level of income increases to Yb2 and the interest rate decreases to rb2. Now, as the interest rate of countryB decreases but for countryA remains same at ra1. So, there will be massive capital inflow in countryA, that increase the supply of foreign exchange. Now, under the fixed exchange rate regime there will be excess supply of foreign exchange, => central bank of A have to buy the excess amount of foreign exchange reserve in exchange money. So, the money supply of A also increases and the LMa shift right to LMa2. So, the equilibrium interest rate decreases to ra2 and the income increases to Ya2.

So, by using monetary policy B can increase the output of A.

Rahul Sunny answered 6 months ago

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