If a country chooses to have free capital flows and to conduct an independent monetary policy, then it must:
A) live with exchange-rate volatility.
B) restrict its citizens from participating in world financial markets.
C) give up the use of monetary policy for purposes of domestic stabilization.
D) have a fixed exchange rate.

Question

Quizplus · Accepted Answer

Free capital flows and an independent monetary policy mean that the country's central bank can adjust interest rates to stabilize the domestic economy. However, this may lead to fluctuations in the exchange rate as investors react to these changes in interest rates. Therefore, the country must be willing to live with exchange-rate volatility. Choice B is incorrect because free capital flows mean that citizens can participate in world financial markets. Choice C is incorrect because independent monetary policy allows the country to use monetary policy for domestic stabilization. Choice D is incorrect because having a fixed exchange rate would require giving up the freedom of capital flows or an independent monetary policy.

If a Country Chooses to Have Free Capital Flows and to Conduct