With pegged exchange rates, in the case of fiscal dominance, if investors are unaware of pending problems as the central bank continuously monetizes government bonds, then at some point:
A) the IMF will step in and take over management of the currency.
B) the nation will reverse course and begin accumulating foreign currency reserves.
C) reserves will run out, the money supply and inflation will rise, and after that point the fixed exchange rate cannot be sustained.
D) the government will be forced to give up control of the central bank.

Question

Quizplus · Accepted Answer

If investors are unaware of pending problems and the central bank continuously monetizes government bonds, at some point reserves will run out, the money supply and inflation will rise, and after that point the fixed exchange rate cannot be sustained. This is because the central bank will likely continue to print money to fund the government's spending, causing inflation to rise and diminishing the value of the currency. Once reserves run out, the government may be forced to devalue the currency or abandon the pegged exchange rate. The IMF may step in to provide support, but it is not guaranteed. Option A and D are not likely to happen as the government is unlikely to give up control of the central bank voluntarily or be forced to do so by the IMF. Option B may be an option, but it is not guaranteed to happen and does not address the underlying issue of fiscal dominance.

With Pegged Exchange Rates, in the Case of Fiscal Dominance