Assume that the economy is operating in a fixed exchange rate regime and that perfect capital mobility exists. Given this information, which of the following will occur?
A) The central bank cannot use monetary policy independently to affect domestic output.
B) Contractionary fiscal policy will require the central bank to decrease the money supply.
C) The domestic and foreign interest rates must be equal.
D) All of the above.
E) None of the above.

Question

Quizplus · Accepted Answer

A) In a fixed exchange rate regime with perfect capital mobility, the central bank cannot use monetary policy independently to affect domestic output as any change in interest rates will result in capital flows in and out of the country to maintain the fixed exchange rate.
B) Contractionary fiscal policy can lead to a decrease in aggregate demand which can result in a decrease in the money supply if the central bank engages in contractionary monetary policy to maintain the fixed exchange rate.
C) In a fixed exchange rate regime with perfect capital mobility, interest rates must be equal to avoid arbitrage opportunities for investors. If there is a difference in interest rates, investors will move their capital to take advantage of the higher interest rate, which can cause a change in the exchange rate to maintain equilibrium. 
Therefore, all three statements are correct, and the answer is D.

Assume That the Economy Is Operating in a Fixed Exchange