Question

1. Assuming the free flow of capital across borders, if country A wants to fix its exchange rate without country B, then:

(A) country A's inflation rate will have to match country B's.

(B) country A's monetary policy must be conducted so the inflation rate in country A matches the inflation rate in country B.

(C) country A's monetary policy will not be able to be used to address domestic issues.

(D) all of the answers given are correct.

2. Why does the Fed have to be connected with money growth even though their main focus seems to be on interest rates?

3. What are the determinants of the potential output for an economy?

4. Why can monetary policymakers neutralize demand shocks but not supply shocks?

5. Explain why changes in the central bank’s inflation target will shift the dynamic aggregate demand curve.

Answer 1

Question 1 : Assuming the free flow of capital across borders, if country A wants to fix its exchange rate without country B, then:

Solution :   

The option (C) will be corrected here i.e.,  country A's monetary policy will not be able to be used to address domestic issues.

As Trilemma Mechanism which has three sides of triangle i.e., Free Flow of Capital , Fixed Exchange Rate and Independent Monetary Policy . There is mutual exclusive between each side of triangle.

If a country A choose fix exchange rate without country B and have a free flow of capitals across borders then independent monetary policy is not attainable by the nation A . Because interest rate fluctuations would be created as a result Currency Arbitrage will generate the pressure on currency pegs and ultimately causing them to break.

Hence, Monetary policy of nation A will not be able to more address domestic issues .