Question

(T / F) Please state True or false for the following questions and explain your reasons.

1. A transitory fiscal expansion with fixed exchange rates raises the stock of foreign exchange reserves of the central bank. True or false, and why?
2. Permanent increases in the money supply are more effective in raising the level of income under a flexible exchange rate system than under a fixed exchange rate system. True or false, and why?

Answer 1

The statement is not true because with a fiscal expansion having fixed exhange rates decreases the foreign exhange reserves rather increasing it, this is because an increase in government spending eventually cut taxes and lower the burden of taxes, this will increase the demand for good and services in the economy, decrease in taxes will also increse the disposable income in the economy. All these factors will increase the aggregate demand in the economy leading to increase in GNP and the rise in real money demand and which will ultimately make the central bank or the government increase the interest rates. With higher interest rates, return on asset of that country would be higher and the will lead investors invest in that country , leading to appreciation of that currency. But as it has pegged the exhange rate to meet the higher demand of the currency e.g. dollars by buying other currency such as pounds or euro by using dollars. Thus, This will lead to decrease in foreign reserves so, the satement is false.

The floating or flexible exchange rate is the rate that is determined by the forces in the market. The market forces affecting the floating exchange rate are demand and supply of the money, exports, and import quantity and governmental regulations.

On the other hand, the fixed exchange rate is the rate that is kept constant by the government or the central bank. This is also known as the pegged exchange rate as discussed ealier. In the case of this type of exchange rate the rate is not affected by the forces of the market rather it remains fixed irrespective of the market the working.

If the system was the floating-rate an increase in income will result in increased consumption or demand resulting in an increase in inflation rate and an increase in the interest rate. In short, the effect of increased income gets nullified in the economy. On the other hand increase in income will be more effective in the case of a fixed exchange rate system. As in a fixed exchange rate system, there will be a very low inflation rate even if the consumption rises and the effect of rising does not get nullified. Thus this statemet is also false.