In the Mundell-Fleming model, assuming a fixed exchange rate regime, what happens when the country's central bank attempts to reduce the money supply to control inflation?A.A. Exchange rate rises, money supply increases. B.B. Exchange rate rises, money supply decreases. .C.C. Exchange rate falls, money supply increases. D.D. Exchange rate falls, money supply decreases.
Question
In the Mundell-Fleming model, assuming a fixed exchange rate regime, what happens when the country's central bank attempts to reduce the money supply to control inflation?A.A. Exchange rate rises, money supply increases. B.B. Exchange rate rises, money supply decreases. .C.C. Exchange rate falls, money supply increases. D.D. Exchange rate falls, money supply decreases.
Solution
In the Mundell-Fleming model, under a fixed exchange rate regime, when a country's central bank attempts to reduce the money supply to control inflation, the following happens:
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The central bank sells domestic currency in the foreign exchange market, which leads to a decrease in the money supply. This is because when the central bank sells domestic currency, it is essentially taking that currency out of circulation, thus reducing the money supply.
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The selling of domestic currency in the foreign exchange market leads to an increase in the demand for foreign currency, which in turn leads to an appreciation of the foreign currency. However, because the exchange rate is fixed, the central bank must intervene to prevent the foreign currency from appreciating.
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The central bank intervenes by buying back the domestic currency it had previously sold. This action increases the money supply, counteracting the initial decrease.
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The end result is that the money supply remains unchanged, and the exchange rate remains fixed.
So, none of the options A, B, C, D is correct. The correct answer should be: Exchange rate remains fixed, money supply remains unchanged.
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