In a small open economy with a fixed exchange rate, if the central bank decreases the money supply, then in the new short-run equilibrium：A.The exchange rate risesB.income risesC.income fallsD.income remain constant
Question
In a small open economy with a fixed exchange rate, if the central bank decreases the money supply, then in the new short-run equilibrium：A.The exchange rate risesB.income risesC.income fallsD.income remain constant
Solution
In a small open economy with a fixed exchange rate, if the central bank decreases the money supply, it will lead to an increase in interest rates. Higher interest rates attract foreign investors looking for a higher return on their investment, which increases the demand for the domestic currency, causing its value to rise. Therefore, the correct answer is A. The exchange rate rises.
However, the effect on income can vary. The increase in interest rates can reduce investment and consumption, leading to a decrease in aggregate demand, which can cause income to fall. So, C. income falls could also be a possible outcome. But the exact effect on income will depend on other factors in the economy, such as the responsiveness of investment and consumption to changes in interest rates, and the level of spare capacity in the economy.
Similar Questions
Suppose that in a small open economy with perfect capital mobility and a floating exchange rate, the central bank increases the money supply because the economy is in a recession. This will cause the equilibrium income to _____ and the equilibrium exchange rate to _____.decrease; risedecrease; fallincrease; fallincrease; rise
Consider a small open economy that is operating under a floating-exchange-rate regime with perfect capital mobility. In this economy, an increase in government spending would cause the equilibrium income to:decrease and the exchange rate to increase.increase and the exchange rate to decrease.increase and the exchange rate to remain unchanged.remain unchanged and the exchange rate to increase.
The central bank of a small open economy with perfect capital mobility and a fixed exchange rate can increase equilibrium income by:devaluing the currency.shifting the LM* curve to the left.allowing the currency to float while retaining a fixed exchange rate.revaluing of the currency.
The graph shows IS*-LM* short-run equilibrium analysis of tight fiscal and monetary policies in a fixed exchange rate regime. Assume a small open economy, which of the following statements is not true about the graph:A.The final short-run equilibrium of the economy is at point B with lower output and exchange rate maintained at its target.B.The change in fiscal policy caused downward pressure on the exchange rate, which was eased with monetary tightening by the central bank.C.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank increased interest rates that attracted capital inflows.D.To maintain the target exchange rate (et), given the downward pressure to fall to e2, the central bank purchased domestic currency (or sold foreign currency).
In the short-run open economy model, What is fixed exchange rate regime implies? A. The government can adjust interest rates freely B. Capital flows are completely unrestricted C. The government cannot influence the exchange rate D. Inflation rates are fixed
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