Question

question 9

a) Automatic adjustment and policy implementation can be applied to overcome internal and external disequilibrium in a country that adopts fixed exchange rate. Discuss with the help of appropriate diagrams how these two mechanism can be implemented to solve this disequilibrium.

Answer 1

In a country that adopts fixed exchange rate though monetary policy cannot be so much effective fiscal policy can effect that country's economy . An expansionary fiscal policy which means increase in govt spending or fall in tax can increase GNP keeping the fixed exchange rate and interest rate unchanged. Thus trade balance and unemployment can be reduced. exact opposite things happen when govt takes contradictory fiscal policy.

Fixed exchange rate has the automatic mechanism , mainly known as the price-specie-flow mechanism, where due to fixed exchange rate there is an adjustment in balance of payments and the internal and external affairs can be kept balanced. If a country has current account surplus price increases,thus domestic goods become expensive in the foreign market, this reduces the current account surplus in the home country and current account deficit in the foreign country. To keep domestic currency from depreciating central bank of domestic country would sell the FOREX that would lowers the reserve and the money stock of the country and LM curve will shift leftward until the external balance is restored.