Tightening monetary policy to address twin deficits under fixed exchange rates

Steps:

• Identify goals: Reduce current account deficit (improve trade balance) and lower inflation.
• Consider fixed exchange rate constraint: Limits currency devaluation; focus on domestic policies.
• Evaluate options: Fiscal expansion worsens deficits; monetary tightening curbs demand and capital inflows.
• Select best: Higher interest rates reduce spending, imports, and inflation while attracting capital to support the currency.

Why D is correct:

• Increasing interest rates raises borrowing costs, reducing aggregate demand, which curbs inflation and import demand per the absorption approach (CA = Y - A, where higher rates lower absorption A).

Why the others are wrong:

• A: Devaluation is not feasible under fixed rates without breaking the peg.
• B: Increases aggregate demand, worsening inflation and current account deficit.
• C: Boosts disposable income and spending, fueling inflation and imports.

Final answer: D