The graph shows IS*-LM* short-run equilibrium analysis of tight fiscal and monetary policies in a fixed exchange rate regime. Assume a small open economy, which of the following statements is not true about the graph:A.The final short-run equilibrium of the economy is at point B with lower output and exchange rate maintained at its target.B.The change in fiscal policy caused downward pressure on the exchange rate, which was eased with monetary tightening by the central bank.C.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank increased interest rates that attracted capital inflows.D.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank purchased domestic currency (or sold foreign currency).
Question
The graph shows IS*-LM* short-run equilibrium analysis of tight fiscal and monetary policies in a fixed exchange rate regime. Assume a small open economy, which of the following statements is not true about the graph:A.The final short-run equilibrium of the economy is at point B with lower output and exchange rate maintained at its target.B.The change in fiscal policy caused downward pressure on the exchange rate, which was eased with monetary tightening by the central bank.C.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank increased interest rates that attracted capital inflows.D.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank purchased domestic currency (or sold foreign currency).
Solution
The statement that is not true about the graph is D. "To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank purchased domestic currency (or sold foreign currency)."
In the context of a fixed exchange rate regime, when there is downward pressure on the exchange rate due to tight fiscal policy, the central bank would typically respond by tightening monetary policy, i.e., raising interest rates to attract capital inflows, not by intervening directly in the foreign exchange market. This is because higher interest rates make domestic assets more attractive to foreign investors, leading to an increase in demand for the domestic currency, which helps to maintain the exchange rate at its target level. Therefore, statement D is incorrect.
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