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Implication of monetary policy under fixed exchange-rate system on balance of payment

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What happens to the balance-of-payments under a fixed exchange-rate system when expansionary or contradictory monetary policy is used?

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Solution Summary

Monetary policy expansion under the fixed exchange-rate regime, will worsen the balance of payment account. First, monetary expansion will lead to current account deficit due to the increase in import demand as a result of higher domestic income. Second, lower interest rate will cause capital outflows and this will lead to capital account deficit. The higher the degree of capital mobility the greater the capital account deficit will be. Therefore, in total the balance of payment account will be in bigger deficit as a result of monetary expansion. The solution is 152 words in total.

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Expansionary monetary policy in the fixed exchange-rate system will worsen the balance of payment account. However, the extent of worsening of the balance of payment account depends on the degree of international capital mobility. ...

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