Question

3. Explain why an expansionary monetary policy is not useful for a small open economy with fixed exchange rate.

4.Explain why an expansionary monetary policy is effective for a small open economy with flexible exchange rate.

Answer 1

Question:

3). Answer:

Fixed exchange rate region is a region in which exchanged rate keep fixed with other currency. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band. When the central bank adopts a expansionary monetary policy then its increase money supply. Increasing money supply increase demand for money and increasing demand for money increase AD that increase output and price level. When price level increase its increase inflation and increasing inflation decrease purchasing power of domestic currency and currency get depreciated. Depreciated currency is not acceptable in the fixed exchage rate region so, the central bank sell foreign currency in the foreign exchange market that appreciate the exchage rate at the prefixed/decided level. Appreciating currency cancel the effect of expansionary monetary policy

4). Answer:

In the flexible exchange rate system exchange rate is determined by demand and supply of the currency and the government and central bank do not interfere in the forex market. When the central bank adopts a expansionary monetary policy then its increase money supply. Increasing money supply increase demand for money and increasing demand for money increase AD that increase output and price level. When price level increase its increase inflation and increasing inflation decrease purchasing power of domestic currency and currency get depreciated. But here the central bank does not interfere in the forex market and depeciating currency increase export also.