In a short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease in the interest rate and:
A) the exchange rate but has no effect on income.
B) the exchange rate, and increases in income, net capital outflow, and net exports.
C) the exchange rate and net capital outflow, and increases in income and net exports.
D) net exports and net capital outflow, but increases in investment and income.

Question

Quizplus · Accepted Answer

According to the short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease in the interest rate, which leads to an increase in investment and aggregate demand. This increase in demand causes an increase in output and prices, which, in turn, leads to an increase in imports and a decrease in net exports. The decrease in net exports causes a decrease in the demand for the domestic currency, which leads to a depreciation of the currency. This depreciation of the currency makes the country's goods and services cheaper for foreign buyers, which increases net exports. Thus, a monetary expansion causes an increase in income, net exports, and net capital outflow, and a decrease in the exchange rate. Choice B is the only option that includes all these effects.

In a Short-Run Model of a Large Open Economy with a Floating