In the New Keynesian open economy model with a flexible exchange rate, suppose that the output gap is initially zero and there is an increase in labour supply. What is the correct policy response
To keep the output gap at zero?

Question

Quizplus · Accepted Answer

In the New Keynesian open economy model, an increase in labor supply can potentially increase output. To keep the output gap at zero, the central bank can increase the money supply to accommodate the increased labor supply, ensuring that the increase in potential output does not lead to deflationary pressures. This action helps maintain economic stability by supporting demand to match the increased supply.

In the New Keynesian Open Economy Model with a Flexible