Which of the following is likely to be a cost of the introduction of a fixed exchange rate?

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BlackTom AI · Accepted Answer

The question asks: Which of the following is likely to be a cost of the introduction of a fixed exchange rate?

First, note that the provided data includes an answer claim: 'The central bank will have less flexibility in implementing monetary policy' as the correct option. However, the list of answer options is missing from the dataset, so we cannot analyze each alternative individually. In such cases, we can still discuss the concept behind the stated correct option and why it is generally considered a cost.

Reason this option is a cost: A fixed exchange rate regime typically requires a country to align its monetary policy with the policy stance of the country whose currency it pegs to (often a major economy). To maintain the peg, the central bank may need to adjust interest rates, engage in open market operations, or even use foreign exchange reserves to defend the peg. This constrains the central bank’s ability to pursue independent macroeconomic objectives, such as stabilizing domestic inflation or responding to shocks, thereby reducing monetary policy autonomy and flexibility.

If the exchange rate is fixed, any attempt to change domestic policy to address local conditions (e.g., inflation, unemployment, output gaps) may be limited or timed to avoid compromising the peg. This trade-off is a classic cost cited in open-economy macroeconomics.

Potential related costs that are commonly discussed (even though not listed as options here) include:
- Loss of monetary policy autonomy or independence due to the need to maintain the peg.
- Higher susceptibility to speculative attacks if markets doubt the fixed rate, requiring costly reserve buildup.
- Transmission of external shocks to domestic economy if the peg forces policies that are misaligned with domestic conditions.
- Requirement to hold large foreign exchange reserves to defend the peg, tying up financial resources.

Given that the only explicitly provided answer asserts reduced monetary policy flexibility, this matches the standard cost associated with fixed exchange rate regimes. If there were other options, we would evaluate them against these core principles: compatibility with the peg, reserve requirements, susceptibility to external shocks, and the trade-off between stability of the exchange rate and domestic macroeconomic control.

ECON1002 Introductory Macroeconomics

Which of the following is likely to be a cost of the introduction of a fixed exchange rate?

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