Suppose that country A pegs its currency to that of country B. Now suppose that there is an adverse demand shock in country A. Country B is more likely to cooperate and increase its money supply in response to country A's adverse demand shock when:
A) country B's output is below its preferred level.
B) country B is experiencing high rates of inflation.
C) country B wants country A to devalue its currency.
D) country A is experiencing high rates of inflation.

Question

Quizplus · Accepted Answer

When country A pegs its currency to country B, country A gives up its ability to use monetary policy to respond to shocks. Therefore, if there is an adverse demand shock in country A, the burden of adjustment falls on country B. If country B's output is below its preferred level, it has a greater incentive to cooperate with country A and increase its money supply to help boost demand and output. However, if country B is experiencing high rates of inflation, it may be less willing to increase its money supply as it could exacerbate inflationary pressures. Option C is not a relevant factor in this scenario. Finally, if country A is experiencing high rates of inflation, it would be indicative of a different situation and may not affect the likelihood of country B cooperating.

Suppose That Country a Pegs Its Currency to That of Country