In a small open economy with a fixed exchange rate, if the country devalues its currency, then in the new short-run equilibrium the exchange rate ______, and the LM* curve shifts to the ______.
A) decreases; left
B) increases; left
C) decreases; right
D) increases; right

Question

Quizplus · Accepted Answer

When a country devalues its currency, the exchange rate decreases, making the country's exports cheaper and imports more expensive. This leads to an increase in net exports, which shifts the IS* curve to the right. To maintain the fixed exchange rate, the central bank must purchase domestic currency and sell foreign reserves, which shifts the LM* curve to the right. Therefore, in the new short-run equilibrium, the exchange rate decreases, and the LM* curve shifts to the right.

In a Small Open Economy with a Fixed Exchange Rate