In a small open economy with a floating exchange rate, the supply of real money balances is fixed and a rise in government spending:
A) raises the interest rate, so that income must rise to maintain equilibrium in the money market.
B) raises the interest rate so that net exports must fall to maintain equilibrium in the goods market.
C) cannot change the interest rate so that net exports must fall to maintain equilibrium in the goods market.
D) cannot change the interest rate so income must rise to maintain equilibrium in the money market.

Question

Quizplus · Accepted Answer

In a small open economy with a floating exchange rate, a rise in government spending will lead to an increase in aggregate demand. This will cause the real exchange rate to appreciate, making domestic goods more expensive relative to foreign goods. As a result, net exports will fall. The interest rate will not change, as the central bank will accommodate the increase in aggregate demand by increasing the supply of money.

In a Small Open Economy with a Floating Exchange Rate