Suppose Country X has a floating exchange rate. If the government of Country X engages in contractionary monetary policy, (Change in M less than 0), which of the following is FALSE?A.M / P DecreasesB.L(r*,Y) DecreasesC.Y DecreasesD.LM* Curve shifts right
Question
Suppose Country X has a floating exchange rate. If the government of Country X engages in contractionary monetary policy, (Change in M less than 0), which of the following is FALSE?A.M / P DecreasesB.L(r*,Y) DecreasesC.Y DecreasesD.LM* Curve shifts right
Solution
The statement that is FALSE is D. LM* Curve shifts right.
Here's why:
A. M / P Decreases - This is TRUE. Contractionary monetary policy means the money supply (M) decreases. If the price level (P) remains constant, then the ratio of M / P decreases.
B. L(r*,Y) Decreases - This is TRUE. L(r*,Y) represents the liquidity preference, which is the demand for money. If the money supply decreases due to contractionary monetary policy, the liquidity preference decreases.
C. Y Decreases - This is TRUE. Y represents income or output. Contractionary monetary policy reduces the money supply, which leads to higher interest rates. Higher interest rates discourage investment, leading to a decrease in income or output.
D. LM* Curve shifts right - This is FALSE. The LM* curve represents the relationship between the interest rate and income when the money market is in equilibrium. Contractionary monetary policy, which reduces the money supply, would shift the LM* curve to the left, not to the right. This is because a decrease in the money supply leads to higher interest rates for a given level of income, which is represented by a leftward shift of the LM* curve.
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