Answer to Question 2:

Regardless of whether the exchange rate is fixed or flexible there is a combination of monetary and fiscal policy that will bring the economy to full employment without an actual change in the exchange rate or in official foreign exchange reserves.

True or False?


The answer is True. Suppose the exchange rate is fixed. Then a fiscal expansion to shift IS to cross ZZ at the full-employment level of output can be accompanied by a corresponding purchase of bonds by the central bank to increase the money supply until LM also crosses ZZ at the full-employment level of output. If the exchange rate is flexible that same increase in the money supply will shift the LM curve to pass through ZZ at full-employment. The previous dose of fiscal policy can then be applied to shift IS to pass through this LM-ZZ intersection. Since domestic residents will be in portfolio equilibrium at that level of output there will be no pressure on the nominal and real exchange rates.

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