If a country chooses to have free capital flows and to maintain a fixed exchange rate, 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) give up the use of fiscal policy for purposes of domestic stabilization.

Question

Quizplus · Accepted Answer

When a country chooses to have free capital flows and maintain a fixed exchange rate, it cannot use monetary policy to stabilize the domestic economy. This is because changes in the demand for money influence the exchange rate, which, in turn, reflects the balance of payments. If a central bank attempts to offset these changes by changing the money supply, this can create inconsistencies that undermine the fixed exchange rate. As a result, countries pursuing this policy may be forced to accept exchange rate volatility, particularly in response to changes in the business cycle. However, this does not require restricting citizens from participating in world financial markets or giving up fiscal policy.

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