Answer to Question #235689 in Macroeconomics for Jelly

Question

2.1 Under fixed exchange rate regime, appreciation pressure on exchange rate will results in capital inflows. True or false? Explain your answer. (5 marks)

2.2. The impossible trinity suggests that a central bank can prevent a balance-of-payments crisis by limiting the cross-border flows of capital. True or false? Explain your answer. (5 marks)

Answer 1

Solution:

2.1). True

Under a fixed exchange rate system, appreciation pressure on the exchange rate will arise. This is an increase in the value of one currency relative to another currency. This will make imports cheaper and increase domestic money demand. This will ultimately lead to capital inflows since there will be an increase in the amount of capital coming into a country in the form of foreign investments.

2.2). False.

The main cause of a balance of payments crisis is the halt in capital inflows, therefore limiting cross-border flows of capital will make the situation much worse.

Under impossible trinity, the central bank faces two out of three choices on maintaining a fixed exchange rate, cross-border capital flows, and independent monetary policy. Therefore, a central bank can prevent a balance of payments crisis through independent monetary policies such as currency devaluation, exchange control, and export promotion.