Assume also that goods prices are sticky in the short run. Suppose the US central bank...

Assume also that goods prices are sticky in the short run. Suppose the US central bank wishes to ﬁx the exchange rate at the level before implementing the contractionary monetary policy. At the same time, the US central bank faces the Trilemma. What policy options are available to the central bank?

Expert Solution

If the price level in the nation are sticky in the short run, a contractionary monetary policy will lead to a fall in the aggregate demand curve as the demand of the people will fall. The price level will reduce and so will the output level but since the price level is fixed, the supply curve will move towards the left and the price level will be restored reducing the output level further.

If the central bank fixes the exchange rate before the contractionary monetary policy, the supply curve will shift to the right thereby increasing the exchange rate and reducing the output level. But since the exchange rate is fixed, the demand curve will shift to the left and fixed exchange rate will be restored. The output will fall.

The other options that the central bank has is to not fix the exchange rate and let the floating exchange rate take place. The exchange rate will balance itself through this .

The central bank may also not keep the prices sticky in the short run which will lead to a fall in the price meaning a reduction in inflation as well as the output.

These are the other options available to the central bank.

Rahul Sunny answered 6 months ago

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