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    Monetary policy and exchange rates

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    Suppose that the Bank of Canada decides to expand the money supply.
    * Why would it be counterproductive for the Bank of Canada to fix the value of the exchange rate?
    * What is the effect of this policy on the interest rate in the long run? How do you know?
    * What characteristic of the economy makes the short-run effect monetary policy on the interest rate different from the long-run effect?

    Suppose that survey measures of consumer confidence indicate that a wave of pessimism is sweeping the country.
    * If policy makers do nothing, what will happen to aggregate-demand?
    * What should the Bank of Canada do if it wants to stabilize aggregate-demand?
    * If the Bank of Canada does nothing, what might Parliament do to stabilize aggregate-demand?

    What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve?

    Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve. Consider the effects in both a closed economy and a small open economy.

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    Solution Preview

    Fixing the value of the exchange puts pressure on the government to keep the currency from falling. Whenever market forces cause the currency to fall, the central bank must sell reserves of foreign currency in exchange for dollars at the fixed exchange rate. These sales of foreign currency result in a reduction in the money supply. This is because when the central bank buys dollars in the private FOREX, it is taking those dollars out of circulation and thus out of the money supply. The net effect of this move is therefore zero.

    When the money supply ...

    Solution Summary

    How fixed and flexible exchange rates affect monetary policy decisions.