Under ²oating exchange rates increased volatility of

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Under ²oating exchange rates, increased volatility of exchange rate can cause a number of problems: (a) speculations on the changes in the exchange rate can lead to instability in the foreign exchange market and, in turn, have negative e/ects for countries´internal and external balances; (b) ²oating exchange rates make relative international prices move unpredictably, which would hurt international trade and investment. (c) there will be reduced incentive for the central bank to follow monetary discipline: Central banks freed from their obligation to µx the exchange rates might embark on in²ationary policies. As a result, some monetary policy autonomy might willingly be sacriµced to reduce these problems. Policy-makers might also sacriµce autonomy to enter into cooperative arrangements with foreign policy-makers that reduce the risk of °beggar-thy-neighbor±policy actions. 3. Problem 8, Chapter 17 in KO, 8th edition. The reason that the e/ects of temporary and permanent µscal expansions di/er un- der ²oating exchange rates is that a temporary policy has no e/ect on the expected exchange rate while a permanent policy does. The AA curve shifts with a change in the expected exchange rate. In terms of the diagram, a permanent µscal expansion causes the AA curve to shift down and to the left which, combined with the outward shift in the DD curve, results in no change in output. With µxed exchange rates, however, there is no change in the expected exchange rate with either policy since the exchange rate is, by deµnition, µxed. In response to both temporary and permanent
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