In the Mundell-Fleming model with fixed exchange rates, attempts by the central bank to increase the money supply lead the exchange rate to fall, giving arbitrageurs the incentive to ______ the central bank, which causes the money supply to ______.
A) sell domestic currency to; increase
B) sell domestic currency to; decrease
C) buy domestic currency from; increase
D) buy domestic currency from; decrease

Question

Quizplus · Accepted Answer

In the Mundell-Fleming model with fixed exchange rates, an increase in the money supply causes the interest rate to fall, which leads to a decrease in the demand for the currency and a fall in the exchange rate. This creates an incentive for arbitrageurs to sell the domestic currency, which puts pressure on the central bank to buy up the excess supply of the currency. To do this, the central bank must decrease the money supply. Therefore, attempts by the central bank to increase the money supply lead to a fall in the exchange rate and a subsequent need to sell domestic currency, causing the money supply to decrease.

In the Mundell-Fleming Model with Fixed Exchange Rates, Attempts by the Central