Which of the following is a potential downside for a country that adopts a fixed exchange rate system?

• A. It eliminates the need for foreign currency reserves.
• B. It increases exchange rate volatility.
• C. It may lose control over its domestic monetary policy.
• D. It guarantees automatic adjustment to trade imbalances.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand what a fixed exchange rate system means. In this system, a country pegs its currency's value to another currency or a basket of currencies, maintaining a stable exchange rate.
2. Step 2: Recognize that maintaining a fixed exchange rate requires the central bank to intervene in the foreign exchange market, often by buying or selling foreign currency reserves to keep the exchange rate stable.
3. Step 3: Analyze the implications for domestic monetary policy. Because the central bank must focus on maintaining the fixed exchange rate, it may have limited ability to adjust interest rates or use other monetary tools to respond to domestic economic conditions.
4. Step 4: Contrast this with other options: fixed exchange rates do not eliminate the need for foreign reserves (in fact, reserves are crucial), they reduce exchange rate volatility rather than increase it, and they do not guarantee automatic adjustment to trade imbalances.
5. Step 5: Conclude that the main downside is the potential loss of control over domestic monetary policy, as the central bank prioritizes exchange rate stability over other economic objectives.