In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new short-run equilibrium the IS^* curve shifts to the right, raising the exchange rate: A) but not raising net exports or income. B) and net exports but not income. C) and income but not net exports. D) net exports and income.

Question

Quizplus · Accepted Answer

In a small open economy with a floating exchange rate, imposing an import quota initially reduces imports, which could increase demand for domestic goods. However, the exchange rate would adjust (appreciate) to offset this, making exports more expensive and imports cheaper again, thus neutralizing the effect on net exports and income. The adjustment in the exchange rate does not lead to an increase in net exports or income in the short run.

In a Small Open Economy with a Floating Exchange Rate