Questions: Exchange Rate Regimes and Monetary Policy

Question 1

A small open economy has a fixed exchange rate, free capital flows, and a domestic recession. The central bank wants to stimulate growth by cutting interest rates. What is the most likely outcome?

• A. The economy recovers because lower rates boost domestic investment and consumption without affecting the exchange rate
• B. Capital outflows deplete foreign reserves as investors seek higher returns abroad, threatening the fixed exchange rate peg
• C. The exchange rate appreciates as lower interest rates reduce inflation expectations and increase confidence
• D. The fixed exchange rate automatically absorbs the recessionary shock, making interest rate cuts unnecessary

Answer: (B)

Under free capital mobility, investors move capital toward wherever returns are highest. If the domestic central bank cuts rates while foreign rates remain unchanged, capital flows out of the country seeking higher returns abroad. Investors sell domestic currency to buy foreign assets, creating selling pressure that pushes the exchange rate below the peg. The central bank must intervene — buying domestic currency with foreign reserves — to defend the peg. This drain can only continue until reserves are exhausted. The impossible trinity means the rate cut directly conflicts with the fixed-rate commitment; something must give.

Question 2

What does the 'impossible trinity' (Mundell-Fleming trilemma) state?

• A. A country cannot simultaneously achieve low inflation, high output growth, and full employment
• B. A country cannot simultaneously run a fiscal surplus and a trade surplus
• C. A country cannot simultaneously maintain a fixed exchange rate, allow free capital flows, and use independent monetary policy
• D. A country cannot maintain a fixed exchange rate for more than one business cycle without experiencing deflation

Answer: (C)

The trilemma identifies three desirable policy goals that are mutually incompatible: (1) exchange rate stability (fixed rates reduce uncertainty for trade and investment), (2) capital mobility (free flows allow efficient international allocation of savings), and (3) monetary autonomy (ability to set interest rates for domestic stabilization). A country must sacrifice one. Fixed-rate countries with open capital markets sacrifice monetary autonomy. Floating-rate countries gain monetary autonomy but lose exchange rate stability. Capital controls preserve both monetary autonomy and a fixed rate but sacrifice capital mobility.

Question 3

Under a floating exchange rate regime, a currency depreciation following a central bank interest rate cut tends to stimulate exports, providing an additional channel of monetary stimulus.

• T. True
• F. False

Answer: True

When a central bank cuts rates under a floating regime, capital outflows cause the exchange rate to depreciate. A weaker domestic currency makes exports cheaper for foreign buyers and imports more expensive for domestic consumers, boosting net exports. This exchange rate channel reinforces the direct interest rate stimulus — lower rates also reduce borrowing costs domestically. This is one reason monetary policy is considered more potent under floating exchange rates than under fixed rates, where the exchange rate channel is unavailable.

Question 4

A country that adopts a fixed exchange rate gains monetary independence because the stable exchange rate removes uncertainty and gives policymakers clearer targets.

• T. True
• F. False

Answer: False

This reverses the actual implication. Adopting a fixed exchange rate sacrifices monetary independence — it does not create it. With free capital flows, the domestic interest rate must track the foreign rate closely; any deviation triggers capital flows that threaten the peg. The central bank cannot cut rates to fight recession or raise rates to fight inflation without jeopardizing the peg. Countries adopt fixed rates precisely to import the credibility of another country's monetary policy (e.g., dollar pegs), but at the cost of losing the ability to conduct independent domestic stabilization policy.

Question 5

Why does maintaining a fixed exchange rate prevent a central bank from using interest rates to stabilize the domestic economy when capital flows freely?

Model answer: Maintaining a fixed exchange rate requires that the domestic interest rate remain close to the foreign rate. If the central bank cuts rates to fight recession, investors earn higher returns abroad and move capital out of the country, selling domestic currency. This selling pressure pushes the exchange rate below the peg, forcing the central bank to defend it by selling foreign reserves to buy domestic currency. Once reserves are exhausted, the bank must abandon either the peg or the rate cut. With free capital flows, any sustained interest rate gap from the world rate triggers a currency crisis — so monetary policy is effectively constrained to support the peg rather than domestic stabilization.

The mechanism is interest parity: capital flows until expected returns across currencies are equalized. A fixed exchange rate pins the expected exchange rate change to zero, so domestic and foreign interest rates must converge. This constraint eliminates the central bank's freedom to set rates for domestic purposes. The European Central Bank faces a version of this constraint: it sets a single interest rate for the entire eurozone, which is appropriate for some members' conditions but not others — there is no exchange rate adjustment within the zone to compensate.