In a small open economy with perfect capital mobility, if the exchange rate is flexible, what would be the effect of an expansionary monetary policy?
A) It would cause the domestic interest rate to increase permanently.
B) It would cause the domestic interest rate to decrease permanently.
C) It would cause the domestic interest rate to increase temporarily.
D) It would cause the domestic interest rate to decrease temporarily.

Question

Quizplus · Accepted Answer

An expansionary monetary policy would lead to an increase in the money supply, causing a decrease in the interest rate in the short run due to increased demand for credit. This would lead to an increase in investment and consumption, and a decrease in savings. As a result, there would be an increase in aggregate demand, which would lead to inflationary pressures. In the long run, the increase in aggregate demand would lead to an increase in the price level, causing an increase in the domestic interest rate. However, since the exchange rate is flexible, the increase in the domestic interest rate would lead to an increase in demand for the domestic currency, causing an appreciation in the exchange rate. This appreciation would decrease net exports, which would decrease aggregate demand, thereby putting downward pressure on the interest rate. In the end, the increase in the domestic interest rate would be temporary.

In a Small Open Economy with Perfect Capital Mobility, If