In a small open economy with flexible exchange rates, a contractionary monetary policy would
A) cause an exchange rate depreciation in short run.
B) increase domestic output in short run.
C) decrease domestic output in short run.
D) decrease domestic output in long run.

Question

Quizplus · Accepted Answer

A contractionary monetary policy involves the central bank reducing the money supply, which leads to higher interest rates and a decrease in investment and consumption spending. This reduces aggregate demand and output in the short run. Additionally, since flexible exchange rates allow the exchange rate to adjust freely, the decrease in domestic interest rates will cause a decrease in demand for the domestic currency, leading to an exchange rate depreciation. However, the long-run effects depend on how the contractionary policy affects expectations and potential output.

In a Small Open Economy with Flexible Exchange Rates, a Contractionary