If exchange rates are flexible and capital is perfectly mobile, money expansion will lead to
A)an immediate adjustment in the exchange rate, but a gradual adjustment in prices
B)an immediate change in competitiveness
C)a decrease in interest rates and a capital outflow in the short run
D)a proportionate increase in money, prices, and the exchange rate in the long run, leaving output and real money balances unchanged
E)all of the above

Question

Quizplus · Accepted Answer

In a scenario where exchange rates are flexible and capital is perfectly mobile, money expansion impacts the economy in several ways. Initially, there is an immediate adjustment in the exchange rate due to the increased supply of domestic currency, leading to its depreciation. This depreciation affects competitiveness by making domestic goods cheaper relative to foreign goods. Additionally, the expansion in money supply typically leads to a decrease in interest rates, encouraging capital to flow out in search of higher returns elsewhere. Over the long term, the increase in money supply will lead to a proportionate increase in prices and the exchange rate, a concept known as the long-run neutrality of money, where real variables like output and real money balances remain unchanged.

If Exchange Rates Are Flexible and Capital Is Perfectly Mobile