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    Question

    In an open economy with free capital flows, the central bank can

    A Stabilize the exchange rate by setting the rate of interest appropriately Correct Answer Incorrect Answer
    B Stabilize the rate of interest by setting the exchange rate appropriately Correct Answer Incorrect Answer
    C Either set the rate if interest or stabilize the exchange rate, but not both Correct Answer Incorrect Answer
    D Neither stabilize the rate of interest nor the exchange rate Correct Answer Incorrect Answer

    Solution

    This situation is described by the "Impossible Trinity" or "Trilemma" in international economics, which states that it is impossible for a country to have all three of the following at the same time: a fixed foreign exchange rate, free capital movement, and an independent monetary policy. In an open economy with free capital flows, the central bank can either stabilize the exchange rate or set the interest rate, but it cannot do both simultaneously. If the central bank tries to set the interest rate, it loses control over the exchange rate, and vice versa.

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