Question text 2Marks Consider Country A, which uses a fixed exchange rate system, pegging its currency value against the U.K. pounds, and has perfect capital mobility. If the central bank of the U.K. permanently raises the money growth rate from 2% to 4% per year while the U.K. real income growth rate remains the same as before and the real income growth rate of Country A does not change, then the central bank of Country A would have to Answer 4[select: , raise, lower] its money growth rate to Answer 5[select: , raise, lower] its nominal interest rate in the long-run.Notes Report question issue Question 3 Notes

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BlackTom AI · Accepted Answer

The question concerns a small open economy (Country A) with a fixed exchange rate to the U.K. pound and perfect capital mobility. In this setting, the Mundell–Fleming framework implies that monetary policy is constrained when the exchange rate is fixed and capital can flow freely across borders.

First, consider what happens when the U.K. permanently raises its money growth rate (from 2% to 4%) while its real income growth remains unchanged and Country A’s real income growth is also unchanged. A higher money growth in the U.K. tends to put downward pressure on UK interest rates (in the short run) and raises the domestic price level over the longer run, all else equal. With perfect capital mobility, investors would move funds to the country offering higher expected returns, which, in the fixed exchange-rate regime, would translate into pressures on Country A’s monetary stance if the peg is to be maintained.

Now evaluate the implication for Country A under a fixed peg:
- If Country A did not adjust its monetary stance, the interest-rate differential and capital flows would exert pressure on the peg, potentially forcing an appreciation or depreciation depending on the direction of the flow. To defend the fixed rate, Country A must offset these pressures.
- To offset the inflows or outflows and keep the peg anchored, Country A would need to adjust its own money supply. In the long run, this typically requires increasing the domestic money growth to accommodate the higher foreign monetary expansion and to prevent a mismatch that could undermine the peg. Therefore, raising the money growth rate in Country A helps maintain monetary conditions aligned with the currency peg and the capital-flow equilibrium.

With the peg defended and long-run considerations in mind, the domestic nominal interest rate in Country A would adjust in response to the new monetary stance and the resulting price level path. Given the higher foreign money growth and the need to sustain the fixed rate, the long-run adjustment is more consistent with a lower nominal interest rate in Country A relative to the new foreign stance, as inflation and expected inflation rise with higher money growth.

Therefore, the correct sequence is:
- First blank: raise (Country A must raise its money growth rate to defend the fixed peg under the new UK policy environment).
- Second blank: lower (the long-run nominal interest rate in Country A tends to fall as the domestic money supply is increased and inflation expectations rise, given the fixed-rate constraint and capital mobility).

In summary, under a fixed exchange rate with perfect capital mobility, a foreign monetary expansion (UK) puts pressure on the peg. To maintain the peg, Country A needs to raise its own money growth and, in the long run, its nominal interest rate tends to move lower as inflation expectations adapt to the higher money supply. This line of reasoning aligns with the conventional Mundell–Fleming interpretation of policy options under a fixed exchange rate regime with free capital mobility.

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