Suppose that the demand for money were to become increasingly sensitive to changes in the interest rate. In that case, you would expect to see
A) the exchange rate become more sensitive to changes in fiscal policy.
B) the exchange rate become less sensitive to changes in fiscal policy.
C) no change in the sensitivity of the exchange rate to changes in fiscal policy.
D) an influx of foreign demand for domestic currency neutralize the increased sensitivity of domestic demand.
E) none of the above.

Question

Quizplus · Accepted Answer

When the demand for money becomes more sensitive to changes in the interest rate, it implies that even small changes in the interest rate can lead to significant shifts in the demand for money. This increased sensitivity can dampen the impact of fiscal policy on the exchange rate because fiscal policy effects on the exchange rate often work through interest rate changes. If people are more responsive to interest rate changes (in terms of adjusting their money holdings), the direct impact of fiscal policy on the exchange rate might be less pronounced, as the interest rate changes would more efficiently equilibrate money demand with supply without requiring as large adjustments in the exchange rate.

Suppose That the Demand for Money Were to Become Increasingly