1. Illustrate and describe the effects of expansionary monetary policy in a small open economy that...
1. Illustrate and describe the effects of expansionary monetary policy in a small open economy that allows their currency to float. What are the effects on r, e and Y?
Homework Answers
In the diagram, the LM curve shifts rightward as a result of expansionary monetary policy. Then the IS curve also eventually shifts to the right.
Under floating exchange rate, monetary policy is completely effective. This is because with monetary expansion, LM-curve shifts rightward and interest rate decreases. Due to this, there is outflow of capital which causes deficit in BOP account. With capital outflow, domestic currency depreciates. It means domestic goods become relatively cheaper and foreign goods relatively expensive. Therefore, net exports increases and IS shifts rightwards. So monetary policy is effective to increase output under flexible exchange rate system. Lastly, the interest rate remains the same.
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