Question

The effectiveness of monetary policy in influencing national income will, under a system of fixed exchange rates, be ________ under a system of flexible exchange rates.

select one:

a. greater than

b. less than

c. perhaps greater than, perhaps less than

d. the same as

Answer 1

Using the AA-DD model, several important relationships between key economic variables are shown:

• Expansionary monetary policy (↑MS) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short run.
• A monetary policy (change in MS) has no effect on GNP or the exchange rate in a fixed exchange system. As such, the trade balance, unemployment, and interest rates all remain the same as well. Monetary policy becomes ineffective as a policy tool in a fixed exchange rate system.
• Thus the effectiveness of monetary policy in influencing national income will, under a system of fixed exchange rates, be less than under a system of flexible exchange rates.