In a small open economy, if the government adopts a policy that lowers imports, then that policy:
A) raises the real exchange rate and increases net exports.
B) raises the real exchange rate and does not change net exports.
C) raises the real exchange rate and decreases net exports.
D) lowers the real exchange rate.

Question

Quizplus · Accepted Answer

In a small open economy, a policy that lowers imports directly affects the trade balance by reducing the amount of goods and services bought from abroad. However, this action can lead to an appreciation of the real exchange rate because it can reduce the demand for foreign currency (needed to buy those imports), making the domestic currency more valuable in comparison. An appreciated (or raised) real exchange rate makes domestic goods more expensive relative to foreign goods, which could reduce exports and increase imports over time, counteracting the initial policy effect. However, the immediate effect of the policy per the question's framing does not change net exports directly because it specifically targets imports. The change in net exports would depend on subsequent adjustments in the economy, which are not specified in the question.

In a Small Open Economy, If the Government Adopts a Policy