Denmark's Fixed Exchange Rate to the Euro as a Binding Constraint

Bank of England Granted Operational Independence (1997)

Loss of Independent Monetary Policy for Eurozone Members

A country with a history of high and unstable inflation is exploring options to create a credible, long-term commitment to price stability. Policymakers are debating three potential institutional reforms:

1. Completely replacing the national currency with a stable, major international currency.
2. Passing a law that requires the national currency's exchange rate to be maintained at a fixed value against a stable, major international currency.
3. Amending the constitution to grant the nation's central bank full autonomy from the government, with a single, legally-binding mandate to achieve a low inflation target.

Which of these reforms would impose the most severe constraint on the country's ability to use its own monetary policy to address future domestic economic issues, such as a recession?

A government wants to establish a credible, long-term commitment to controlling inflation. Match each potential institutional strategy to its correct description.

Choosing an Inflation-Control Strategy

Comparing Inflation Control Strategies

A country that grants its central bank operational independence with a strict inflation target completely surrenders its ability to influence its own long-term economic growth path through other governmental actions.

A country with a history of high inflation is struggling to convince international investors and its own citizens that it is serious about achieving price stability. The primary cause of the inflation has been the government's tendency to pressure the central bank into creating money to fund public spending. The government now wants to adopt a new institutional framework to build credibility, but it is politically unfeasible to abandon the national currency. Which of the following strategies best addresses the specific root cause of the country's inflation problem while respecting the political constraint?

Comparing Inflation Control Strategies

A country's economy is primarily based on agricultural exports, making it susceptible to shocks from weather events and volatile global commodity prices. The government wants to implement a binding institutional framework to control its persistent inflation. However, it also wishes to preserve some capacity for the monetary authority to soften the impact of severe, sector-specific recessions. Which of the following strategies best balances the need for a credible anti-inflation commitment with the desire for some policy flexibility?

The Credibility of a Fixed Exchange Rate

A country has legally committed to maintaining a fixed exchange rate for its currency against a major, stable foreign currency. The country then experiences a severe domestic recession that is not affecting the anchor currency's economy. What is the primary challenge this country's monetary authorities will face in trying to stimulate their economy?