Assume that there is a simultaneous tax cut and monetary contraction. In a flexible exchange rate regime, we know with certainty that:
A) the exchange rate would increase.
B) the exchange rate would increase and output would decrease.
C) the exchange rate would decrease and output would increase.
D) the exchange rate and output would both increase.
E) the exchange rate would increase and output would remain unchanged.

Question

Quizplus · Accepted Answer

In a flexible exchange rate regime, a tax cut would increase aggregate demand, causing inflationary pressure, which is usually addressed by a monetary contraction. The contraction would lead to an increase in interest rates, attracting foreign capital inflow, thereby increasing the demand for the local currency, and consequently, its exchange rate. Therefore, the exchange rate would increase. Output could either increase or decrease, depending on the size and timing of the tax cut and monetary contraction, as well as on other factors that may influence economic activity.

Assume That There Is a Simultaneous Tax Cut and Monetary