Question

Barbados currently uses a fixed exchange rate regime. If the central bank

were to increase the money supply, what impacts would it have on the

economy? Use a diagram to explain your answer.

Answer 1

The central bank must intervene and sell foreign exchange to buy domestic currency in order to preserve the fixed exchange rate. To restore the initial equilibrium, the foreign exchange market intervention will reduce the domestic money supply and shift the LM curve back to LM.