PS #5_ans_wi2017 - Econ171 Dongwon Lee Econ171...

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Econ171 Dongwon Lee 1 Econ171 International Finance PS #5 Answers I. The Open-Economy Trilemma (a) Policymakers can achieve at most two of the three objectives outlined in the policy trilemma. For example, if the country chooses to fix the exchange rate and allows capital to be freely mobile, then it cannot use monetary policy to stabilize domestic output. With free capital mobility, interest parity condition (UIP) will hold. Therefore, to keep the exchange rate fixed, the country needs to keep ܴ ൌ ܴ and therefore cannot manipulate its interest rate to attempt to stabilize domestic output. The flipside of this example is that if the country wants to use monetary policy to stabilize output and also have free capital mobility, then it must allow the exchange rate to float. Finally, in order to use monetary policy to stabilize output and still maintain a fixed exchange rate, the country would need to restrict capital flows. By restricting capital flows, the country effectively eliminates the UIP constraint because it prevents arbitrageurs from moving capital in and out of the country. (b) Regarding the classification of historical exchange rate regimes, the gold standard was a regime in which policymakers gave up the ability to use monetary policy to stabilize domestic output. That is, they chose to combine policy options 1 and 2. Under the post-Bretton Woods floating exchange rate system, the major industrial countries have chosen to let their exchange rates float against one another in order to preserve their freedom to use monetary policy to stabilize output. Thus, they have chosen to combine policy options 2 and 3. Describing Bretton Woods is somewhat more difficult. In the early years of Bretton Woods, capital mobility was
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