Question

Question 1: Give short answers to the following parts:

Part A. Describe two ways through which the consolidated government (fiscal and monetary authorities) can finance a deficit.

Part B. Evaluate the validity of the following claim: “Under a fixed exchange rate, the monetary authority loses its ability to implement independent monetary policy. Hence, a flexible exchange rate is always preferred to a fixed exchange rate.”

Answer 1

Answer 1 - Two ways through which the government can finance its deficit are -

1 - By the issue of the currency notes or the process called the deficit financing

2 - By the increase in the percentage of taxes implied so as to increase the government revenue.

Answer 2 - Yes the statement is true , this is because in the fixed exchange system , a lot of rigidity is present hence the system is not good enough.

The flexible rate helps to manage the exchange rates in very efficient way through the market mechanism. Hence the flexible system should always be preferred.