Expansionary monetary policy in an open economy with a fixed exchange rate will likely ____ a trade deficit.

Question

BlackTom AI · Accepted Answer

Under a fixed exchange rate and free capital mobility, expansionary monetary policy is ineffective at altering the trade balance — it will not change the trade deficit.

1) Relevant concepts:
- Mundell–Fleming model for an open economy with fixed exchange rates and high capital mobility.
- Exchange rate peg requires central bank intervention to keep the domestic currency at the target parity.
- Capital flows respond to interest differentials; the central bank’s interventions affect the domestic money supply.

2) Step-by-step reasoning:
- Suppose the central bank attempts expansionary monetary policy (increasing the money supply).
- The immediate effect would be a lower domestic interest rate relative to the world rate.
- Investors seek higher returns abroad, causing capital outflows and pressure for the domestic currency to depreciate.
- With a fixed exchange rate, the central bank must prevent depreciation by selling foreign reserves and buying domestic currency.
- Those interventions drain the extra domestic currency created by the original expansionary action.

3) Intermediate steps explained:
- Initial: Money supply up → interest rate down → capital outflow → downward pressure on currency.
- Policy reaction: Central bank sells foreign assets to buy domestic currency → money supply falls back → interest rate returns to world rate → capital flows stop.
- Net effect: Domestic money supply and interest rate return to initial values; exchange rate is unchanged.

4) Why the correct answer is correct:
Because the central bank’s intervention offsets the attempted monetary expansion, aggregate demand, income, and the exchange rate return to their prior levels. Since the trade balance (exports minus imports) depends on the exchange rate and income, and neither is permanently changed, the trade deficit remains unchanged.

5) Why other choices are incorrect:
- “Worsen” would require a sustained depreciation or higher income raising imports; neither occurs under a credible fixed peg with intervention.
- “Reduce” would require improved competitiveness or lower domestic demand for imports; monetary expansion under a peg cannot produce those lasting effects.

6) Conclusion:
Therefore, expansionary monetary policy under a fixed exchange rate will not change the trade deficit, confirming the provided answer: not change.

Expansionary monetary policy in an open economy with a fixed exchange rate will likely ____ a trade deficit.Single choice

Similar Questions

Expansionary monetary policy in an open economy with a fixed exchange rate will likely ____ a trade deficit.

Expansionary fiscal policy in an open economy with a fixed exchange rate is:

In fixed exchange rate system, the following is TRUE except

Expansionary fiscal policy in an open economy with a floating exchange rate will likely:

Contractionary monetary policy in an open economy with a floating exchange rate will likely:

Contractionary monetary policy in an open economy with a fixed exchange rate will likely ____ a trade surplus.

Which is expansionary monetary policy?

Which is contractionary fiscal policy?

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler