Suppose Brazil has a floating exchange rate, and it faces domestic inflation and a trade deficit.Assuming it desires overall balance, if Brazil shrinks its money supply, other things equal one would expect which of the following to occur?
A) inflation to become more severe and the trade deficit to become less severe, an example of policy agreement
B) inflation to become more severe and the trade deficit to become more severe, an example of policy conflict
C) inflation to become less severe and the trade deficit to become less severe, an example of policy agreement
D) inflation to become less severe and the trade deficit to become more severe, an example of policy conflict

Question

Quizplus · Accepted Answer

Shrinking the money supply will lead to a decrease in inflation, as there will be less money chasing the same amount of goods, but it will also lead to a decrease in aggregate demand, which in turn will lead to a decrease in imports and an increase in exports. This will worsen the trade deficit, hence creating a policy conflict.

Suppose Brazil Has a Floating Exchange Rate, and It Faces