Many economists claim that in a small open economy operating under a fixed excha

Question

Many economists claim that in a small open economy operating under a fixed exchange rate regime, the domestic central bank is powerless to control the money supply, and monetary policy is thus powerless as a tool to stabilize domestic output. Do you agree or disagree? Explain. Many economists claim that in a small open economy operating under a fixed exchange rate regime, the domestic central bank is powerless to control the money supply, and monetary policy is thus powerless as a tool to stabilize domestic output. Do you agree or disagree? Explain.

Explanation / Answer

When the domestic central bank declares the fixed exchange rate (ER), it exchanges the home currency for foreign currency at a fixed value, therefore it allows the money supply to change until the equilibrium ER equals the declared ER. Therefore the central bank is powerless to control the money supply.

And the monetary policy is thus powerless, as any try to increase the money supply is ineffective because the money supply must change to ensure that the ER at its declared value.

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