Answer to Question 2:

Suppose that the country is on a fixed exchange rate and the government is forced to sell foreign currency out of its official reserves in return for domestic currency to keep the domestic currency from devaluing in the international market. Taken by itself, this action will

1. reduce the stock of money.

2. reduce the stock of base money.

3. reduce the stocks of both money and base money.

4. reduce the money multiplier.

Choose the correct option.

The right answer is option 3. The sale of reserves will take domestic currency out of circulation, reducing the stock of high-powered money. Given the ratios of currency to deposits on the part of the public and reserves to deposits on the part of the banking system, the money multiplier will remain unchanged and the stock of money will also decline.

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