Question

We learned that changes in exchange rates and the corresponding changes in the balance of trade amplify monetary policy. From the perspective of a nation’s central bank, is this a good thing or a bad thing?

a) Good, as it enhances the effectiveness of monetary policy.
b) Bad, as it creates economic volatility.
c) Good, as it stabilizes international trade.
d) Bad, as it limits the central bank's control.

Answer 1

Exchange rate fluctuations can amplify monetary policy and affect aggregate demand positively, but they can also introduce economic volatility and limit the control of central banks, potentially leading to an unsustainable balance of trade and economic instability.

Step-by-step explanation:

When we look at the impact of changes in exchange rates and their effect on the balance of trade, this amplification of monetary policy can be viewed from different angles. From the perspective of a nation's central bank, changes in exchange rates can be seen as a double-edged sword. On one hand, it can enhance the effectiveness of monetary policy, as it affects the quantity of aggregate demand in the economy which is a critical lever for a central bank's macroeconomic management.

However, it's important to note that if the exchange rates fluctuate too frequently or substantially, this can disrupt international trade and cause trouble in the banking system. These disruptions can lead to an unsustainable balance of trade and potentially large inflows or outflows of international financial capital. Such capital movements could set up the economy for a deep recession if international investors decide to move their money to another country.

In conclusion, while changes in exchange rates can amplify monetary policy, they can also introduce economic volatility, which is generally viewed as negative. Central banks prefer stability, as frequent and large fluctuations can limit their control over the economy and potentially cause broader economic issues.