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

Question

BlackTom AI · Accepted Answer

Under a fixed exchange rate and open capital mobility, monetary expansion is typically neutralized because of the international constraints described by the "impossible trinity" (also called the trilemma).

1. Relevant knowledge points and concepts
- Impossible trinity: a country cannot simultaneously have (a) a fixed exchange rate, (b) free capital mobility, and (c) an independent monetary policy. With any two chosen, the third is lost.
- Mechanism of central bank intervention under a fixed peg: to maintain the peg the central bank must buy/sell foreign reserves to offset pressure on the exchange rate.
- Interest parity and capital flows: a lower domestic interest rate relative to foreign rates induces capital outflows under free mobility.

2. Step-by-step reasoning
- The central bank conducts expansionary monetary policy (increases domestic money supply, M ↑).
- Domestic interest rate falls (i ↓).
- Lower i makes domestic assets less attractive → capital outflows occur (residents/foreign investors shift funds abroad).
- Capital outflows put downward pressure on the domestic currency (pressure to depreciate).
- To maintain the fixed exchange rate, the central bank must intervene: sell foreign reserves and buy domestic currency.
- That intervention reduces the domestic monetary base (offsetting the initial M ↑), driving i back up and reversing the expansionary stimulus.

3. Intermediate steps shown as flow:
M ↑ → i ↓ → capital outflow → depreciation pressure → CB sells foreign reserves & buys domestic currency → M ↓ (offset) → policy effect undone.

4. Why the correct answer is correct
Because the need to defend the fixed exchange rate forces interventions that reverse domestic money changes, the monetary authority effectively loses independent control of monetary policy under free capital mobility—exactly the conclusion of the impossible trinity. Thus expansionary monetary policy is weakened (effectively neutralized).

5. Why other options are incorrect (brief)
- Options claiming strengthening confuse the direction: central bank actions to counter an appreciation would not occur here (the pressure is to depreciate), and even if they did, interventions under a fixed peg counteract rather than amplify domestic monetary effects.
- The option claiming weakening because interventions cause exports to fall/imports to rise misstates the immediate mechanism; the key reason is the trilemma and the sterilizing effect of reserve operations, not directly a change in trade flows.

6. Conclusion
Therefore expansionary monetary policy in an open economy with a fixed exchange rate is weakened due to the impossible trinity. This matches the provided answer: weakened due to the impossible trinity.

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

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