Comparing fixed to flexible exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is:
A) output actually falls less under fixed rate than under floating rate.
B) output actually falls more under fixed rate than under floating rate.
C) output actually remains the same under fixed rate than under floating rate.
D) the currency value grows in a fixed rate system and falls in a flexible system.
E) output grows in a fixed rate system and falls in a flexible system.

Question

Quizplus · Accepted Answer

Under a fixed exchange rate system, the central bank will need to intervene and sell foreign reserves to maintain the fixed exchange rate. This will cause a contraction in the money supply, leading to higher interest rates, lower investment, and lower output. On the other hand, under a flexible exchange rate system, the currency will depreciate, making exports cheaper and more competitive, which will partially offset the negative effect of lower foreign demand on output. Therefore, output falls more under fixed rate than under floating rate.

Comparing Fixed to Flexible Exchange Rate, the Response of an Economy