Question

9. “Under fixed exchange rates the monetary policy is impotent, but the fiscal policy is effective.” Do you agree? Explain.

10. “Chronic budget deficits mean ever-accumulating, unsustainable public debt.” Do you agree? Explain why or why not. Make sure to address the following questions in your essay:

a. What is the relationship between public deficits and debt?

b. What is meant by “sustainable debt”? How do you know whether the public debt sustainable?

c. How is it possible for chronic deficits and sustainable debt to coexist?

d. Is it possible for sustainable debt to transform into unsustainable debt?

e. How is monetization of deficit related to debt sustainability?

Answer 1

9.

I agree with the statement. When fixed exchange rate is maintained, then monetary policy cannot work independently and implement initiatives that can help achieve the objective. For example, if inflation is rising in the economy, then monetary policy should increase the interest rate to curb it. But it will increase the demand of domestic currency and exchange rate will differ from the peg and try to appreciate. It is against the objective of the fixed exchange rate. As a result, the independence as well as the effectiveness of the monetary policy becomes zero. Though, the fiscal policy is effective. As part of the fiscal policy, the government can increase the spending. It will increase the aggregate demand. It will also cause the appreciation of the currency and will try to move away from the peg. Here, the central bank will increase the supply of domestic currency to push the currency back to the fixed exchange rate level. As a result, the aggregate demand will increase to push the economy, but the exchange rate will be maintained at the fixed level, albeit at the cost of the monetary policy that will lose its independence.

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