In a small open economy with a floating exchange rate, if the government decreases the money supply, then in the new short-run equilibrium:
A) income falls and the exchange rate rises.
B) the exchange rate falls and income rises.
C) income remains unchanged but the exchange rate rises.
D) the exchange rate remains unchanged but income falls.

Question

Quizplus · Accepted Answer

When the government decreases the money supply in a small open economy with a floating exchange rate, interest rates rise to balance the money market. Higher interest rates attract foreign capital, appreciating the domestic currency (exchange rate rises). The more expensive domestic currency reduces exports and increases imports, leading to a fall in net exports and thus a decrease in aggregate demand and income.

In a Small Open Economy with a Floating Exchange Rate