Question

1)

In a small open economy, the increase in aggregate demand resulting from an increase in government spending is _____ if the exchange rate is ______ than if it is _______ .

A) larger, flexible, fixed

B) smaller, fixed, flexible

C )always zero

D) larger, fixed, flexible

2)

In a small open economy, the increase in aggregate demand resulting from an increase in the money supply is _____ if the exchange rate is ______ than if it is _______ .

A) larger, fixed, flexible

B) smaller, flexible, fixed

C) larger, flexible, fixed

D) always zero

3)

This chapter explains that expansionary monetary policy reduces the interest rate and thus stimulates demand for investment goods. How does such a policy also stimulate the demand for net exports?

The demand for net exports is stimulated by expansionary monetary policy through the____________ (exchange rate effect/ Money supply effect) . The decline in the interest rate___________ (increase / Decrease) net capital outflow and causes the exchange rate to________ (go up or go down).

4)

Suppose the Bank of Canada contracts the money supply in an effort to reduce aggregate demand by a particular amount, say $10 billion. Assume Canada is a closed economy. The amount by which the Bank of Canada would need to reduce the supply of money to accomplish this goal would be ________ (greater / smaller) than the amount it would need to reduce the supply of money if Canada was an open economy with a flexible exchange rate.

Answer 1

1. Fiscal Policy is more effective than monetary policy under fixed exchange rate system while monetary policy is more effective than fiscal policy under flexible exchange rate system.

Answer: D. In a small economy, the increase in aggregate demand resulting from an increase in government is larger if the exchange rate is fixed than if it is flexible.

2. Answer: C. In a small open economy, the increase in aggregate demand resulting from an increase in the money supply is larger if the exchange rate is flexible that if it is fixed.

3. An expansionary monetary policy has three effects namely wealth effect, interest rate effect and net export effect. An expansionary monetary policy increases the price level. Thus domestic goods become costly in foreign market and foreign goods become cheaper in the domestic market. Thus the country’s import demand increase and export demand decrease. Thus the country’s exchange rate depreciate which will promote more export.

An expansionary monetary policy reduces the rate of interest in the economy. Thus domestic capital flows into foreign country in search of higher return and the exchange rate depreciate and the depreciation in exchange rate stimulates export.

Answer: The demand for net export is stimulated by expansionary monetary policy through the exchange rate effect. The decline in the interest rate increases the net capital outflow and causes the exchange to go down.

4. Answer: The amount by which the Bank of Canada would need to reduce the supply of money to accomplish this goal would be smaller than the amount it would need to reduce the supply of money if Canada was an open economy with flexible exchange rate.