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

Question

BlackTom AI · Accepted Answer

With a fixed exchange rate and open capital mobility, expansionary monetary policy is neutralized because of the impossible trinity (the policy trilemma): a country cannot simultaneously have an independent monetary policy, a fixed exchange rate, and free capital movement.

1. Relevant knowledge points and concepts
- Mundell–Fleming framework for a small open economy: under perfect capital mobility, monetary policy is effective only with flexible exchange rates; with fixed rates it is not.
- The impossible trinity (trilemma): only two of the following three can be achieved at once — fixed exchange rate, independent monetary policy, and free capital flows.
- Central bank intervention: to hold a peg, the central bank must buy/sell foreign reserves to offset currency pressures.

2. Step-by-step reasoning
- The central bank enacts expansionary monetary policy → domestic money supply increases → domestic interest rate falls.
- Lower domestic rates versus world rates induce capital outflows (residents/investors move funds abroad seeking higher returns).
- Capital outflows place downward pressure on the domestic currency (tendency to depreciate).
- Under a fixed exchange rate, the central bank must intervene to prevent depreciation: it buys domestic currency and sells foreign reserves.
- That intervention reduces the domestic money supply, reversing the initial expansionary step and pushing interest rates back up.
- The net effect: the initial monetary expansion is offset by reserve loss and intervention, leaving little or no change in output or interest rate.

3. Intermediate steps / calculations
- Qualitative sequence: ΔM > 0 → Δi < 0 → capital outflow → pressure to depreciate → central bank sells FX reserves → ΔM < 0 (offsets original ΔM).

4. Why the correct answer is correct
- This outcome is a direct consequence of the trilemma: with fixed exchange rates and open capital markets, the country cannot retain an independent monetary expansion — the need to defend the peg forces offsetting actions that neutralize the policy.

5. Why other options are incorrect
- Option A/D: claim strengthening because counteracting an appreciation would boost exports — wrong direction: expansionary policy would create depreciation pressure, not appreciation, and interventions to defend a peg typically reverse monetary expansion, not strengthen it.
- Option C: misstates effects of countering depreciation; defending a peg against depreciation requires selling foreign reserves and contracting money, but the claim about exports falling/imports rising is inconsistent and misinterprets the mechanism. None of these capture the trilemma logic.

6. Conclusion
The expansionary monetary policy is weakened due to the impossible trinity; this matches the given correct answer.

Expansionary monetary policy in an open economy with a fixed exchange rate is:Single choice

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