Question

Suppose the U.S. economy slips into a recession. In response, the Federal Reserve cuts the federal funds rate in order to avoid unemployment. Consider what happens to the following under a fixed exchange-rate regime.
a. Domestic investment would increase
b. Capital inflow would decrease
c. Capital outflow would increase
d. The exchange rate would be unchanged
e. Net exports would be unchanged
f. Aggregate demand would increase

Answer 1

Answer: All Variables will remain unchanged

Explanation:

Monetary Policy has no effect on a country's domestic currency because it is simply ineffective when it is in a fixed exchange rate regime. This is because, when monetary policy is used, it tends to change the exchange rate but because the Fed will be engaging in a fixed exchange regime, it will act to normalise the exchange rate which will bring the currency back to equilibrium.

For instance, if the Fed embarks on expansionary monetary policy and pegs its currency to the Euro. The expansionary policy will lead to a drop in interest rates which is supposed to help GDP. However as a result of lower rates, the dollar will depreciate and more people will demand Euros. The Fed will intervene to keep the Euro and the Dollar at the same level (fixed exchange) and sell Euros in its reserves while reducing dollars. This will bring the interest rate and currencies back to its original level so there will be no benefit.

Monetary policy is ineffective under a Fixed Rate regime so one of the variables will change.