Question

Which of the following is not correct about the effectiveness of monetary and fiscal policies under perfect capital mobility?

• A. Under the fixed exchange rate, monetary policy is powerless to affect output.
• B. Under the fixed exchange rate, the central bank runs an independent monetary policy.
• C. Under the fixed exchange rate, fiscal policy is highly effective.
• D. Under the floating exchange rate, a monetary expansion leads to currency depreciation, increased exports, and increased output.

Hint:

Under a fixed exchange rate, monetary policy is tied to maintaining the exchange rate, while fiscal policy remains effective.

Answer 1

The Correct Option is B

Step 1: Understanding monetary and fiscal policies under capital mobility.
Under perfect capital mobility, the country's monetary policy effectiveness is determined by the exchange rate system. Under a fixed exchange rate, the central bank cannot independently control the money supply since it must maintain the exchange rate peg.

Step 2: Analysis of options.
- (A) Under the fixed exchange rate, monetary policy is powerless to affect output: This is correct. With a fixed exchange rate, the central bank cannot control the money supply without affecting the exchange rate.
- (B) Under the fixed exchange rate, the central bank runs an independent monetary policy: This is incorrect. Under a fixed exchange rate, the central bank must give up independent control of monetary policy to maintain the exchange rate.
- (C) Under the fixed exchange rate, fiscal policy is highly effective: This is correct. Fiscal policy can affect output under a fixed exchange rate system, as the central bank will adjust to accommodate fiscal changes.
- (D) Under the floating exchange rate, a monetary expansion leads to currency depreciation, increased exports, and increased output: This is correct. With a floating exchange rate, an increase in the money supply typically causes the currency to depreciate, which boosts exports and output.

Step 3: Conclusion.
The incorrect statement is (B), as the central bank cannot run an independent monetary policy under a fixed exchange rate.