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Monetaristseptember 2014 q19

R

rlsrachaellouisesmith

Ton up Member
Good morning,
Could you please explain why the answer to this question is B or C?

I thought the floating exchange rate protected countries from external economic shocks, so would not be B...

I didn’t understand what C meant so if you could explain that would be great.

Thank you
 
Hi Rachel,

This was a very difficult question, and before you get too bogged down in the detail, it is worth pointing out that the answer which was originally intended to be the correct one (D) was discovered to not always be correct, so the examiners ended up accepting any answer for this particular question. D was found to not be completely correct as B or C could be the correct answer for the following reasons:
  • B: whereas option A suggests that inflation rates are definitely linked under floating exchange rates (which is incorrect), Option B suggests that there could be a link. This is the case because if inflation in one country means higher prices of oil, for example, and that country exports oil to another, the country importing oil could experience cost-push inflation if the demand for the exported/imported good is price inelastic, meaning the demand for the currency might be unchanged.
  • C: Countries which operate under a floating exchange rate regime experience additional freedom for inflation to vary within the country (inflation rates need not be closely linked) than those that operate under a fixed exchange rate system. If this is taken to mean that ‘domestic inflation is dictated outside of the bounds that would have constrained prices in a fixed rate regime’, then Option C could also be the correct answer.
I hope this helps!
Richie
 
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