Under a fixed exchange rate regime, the emerging market economy (EME) is committed to maintaining its currency’s value relative to the advanced economy’s currency. When the advanced economy’s central bank tightens monetary policy:

• Higher interest rates in the advanced economy attract global capital, causing capital outflows from the EME.
• The EME may experience pressure on its currency to depreciate, as demand for the advanced economy’s currency increases.
• To maintain the fixed exchange rate, the EME’s central bank may need to raise domestic interest rates or use foreign reserves to defend its currency peg, which can lead to economic and financial strain.

A is incorrect: Tightening in the advanced economy generally leads to capital outflows from the EME, not inflows, increasing depreciation pressure on the EME’s currency.
B is incorrect: The opposite is true. To maintain the fixed exchange rate, the EME may need to increase domestic interest rates to match or compete with the advanced economy’s rates.
D is incorrect: The EME’s monetary policy is significantly influenced by the fixed exchange rate regime, as it requires alignment with the advanced economy’s monetary stance to maintain the currency peg.