Answer to Question 3:

When a country fixes its exchange rate, it loses control over its domestic money supply

1. regardless of how the relevant real exchange rate is determined.

2. only if the law of one price holds.

3. only if the relevant real exchange rate is constant.

4. only if there is no inflation in the rest of the world.

Choose the correct option.

The answer option is option 1. The real exchange rate is the relative price of the country's output in terms of the output of the other country. This relative price will change through time as world technology evolves. But its equilibrium level at any point in time will be independent of whether or not the government chooses to fix the nominal exchange rate. Once the government fixes the nominal exchange rate, this given level of the real exchange rate together with the price level in the other country will determine the domestic price level. The domestic money supply will have to be at the level sufficient to just maintain that particular level of domestic prices. There can be no independent domestic monetary policy.

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