In the Mundell–Fleming model with a fixed exchange rate, an attempt by the central bank to lower the money supply cause the exchange rate to rise, giving arbitrageurs the incentive to ______ the central bank, which causes the money supply to ______.A.sell domestic currency to;decreaseB.sell domestic currency to;increaseC.buy domestic currency from;decreaseD.buy domestic currency from;increase
Question
In the Mundell–Fleming model with a fixed exchange rate, an attempt by the central bank to lower the money supply cause the exchange rate to rise, giving arbitrageurs the incentive to ______ the central bank, which causes the money supply to ______.A.sell domestic currency to;decreaseB.sell domestic currency to;increaseC.buy domestic currency from;decreaseD.buy domestic currency from;increase
Solution
The correct answer is D. "buy domestic currency from; increase".
Here's the step by step explanation:
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In the Mundell-Fleming model with a fixed exchange rate, when the central bank attempts to lower the money supply, it sells domestic currency in exchange for foreign currency. This action reduces the amount of domestic currency in circulation, hence reducing the money supply.
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This action causes the exchange rate to rise because the supply of domestic currency decreases while the demand remains the same.
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The rise in exchange rate gives arbitrageurs an incentive to buy the domestic currency from the central bank. Arbitrageurs are individuals or entities that take advantage of differences in exchange rates in different markets to make a profit.
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When arbitrageurs buy the domestic currency from the central bank, they give the central bank foreign currency in exchange. This action increases the money supply because the central bank now has more foreign currency which it can use to buy more domestic currency and put it into circulation.
So, the correct answer is "buy domestic currency from; increase".
Similar Questions
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