In an open economy, monetary policy works through the effect of the interest rat
ID: 1121813 • Letter: I
Question
In an open economy, monetary policy works through the effect of the interest rate on:
A. taxes.
B. the exchange rate.
C. consumption.
D. output.
If interest rates are decreased in an open economy, which of the following is the correct sequence of resulting events?
A. LM increases; output (Y ) increases; exchange rate (E ) decreases
B. LM decreases; output (Y ) increases then decreases; exchange (E ) decreases
C. LM decreases; output (Y ) decreases then increases; exchange rate (E ) increases
D. LM decreases; output (Y ) increases; exchange rate (E ) decreases
In a market with an unchanged current exchange rate where the interest parity condition holds, if investors now expect the exchange rate to be 4.25 % lower a year from now, the return on foreign bonds with an interest rate of 2.25 % would be ___ %.
(Enter your response rounded to two decimal places.)
An increase in the domestic interest rate relative to the foreign interest rate leads to _______.
A. inflation
B. deflation
C. a depreciation
D. an appreciation
Consider an open economy with flexible exchange rates.
Given the discussion of the effects of fiscal policy in this chapter, how does a foreign fiscal expansion affect domestic output if the domestic central bank does not change the policy rate?
A. A foreign fiscal expansion has no effect on domestic output.
B. A foreign fiscal expansion has an ambiguous effect on domestic output.
C. A foreign fiscal expansion is likely to decrease domestic output.
D. A foreign fiscal expansion is likely to increase domestic output.
Given the discussion of the effects of monetary policy in this chapter, how does a foreign monetary expansion affect domestic output?
A. A foreign monetary expansion has an ambiguous effect on domestic output.
B. A foreign monetary expansion is likely to increase domestic output.
C. A foreign monetary expansion is likely to decrease domestic output.
D. A foreign monetary expansion has no effect on domestic output.
Explanation / Answer
1). B). Exchange Rate. An increase or decease in interest rates lead to foreign inflow or outflow from the country, thereby leading to changes in equilibrium output level accordingly.
2). B). LM decreases, output increases then decreases, exchange rate decreases. This is according to the Mundell-Fleming Model under which, a reduced interest rate will first shift the LM curve down to the right; and at the same time will reduce foreign currency inflow in the market. Thus, this leads to reduced exports shifting IS curve to the left. Thus reducing output. Exchange rate decreases since the foreign exchange inflow has reduced, thereby affecting exchange rate downwards.
3). D.) An appreciation. This is because increased domestic interest rate will attract foreign investment, thereby increasing the demand for domestic currency, making it more valuable as against the foreign currency.
4). D). A foreign fiscal expansion is likely to increase domestic output. This is because the foreigners have more real money in their pockets with fiscal expansion, thus they demand more goods.
5). A). A foreign monetary expansion has an ambiguous effect on domestic output. This is because a monetary expansion could either reduce the real value of foreign currency or either increase its real value. The effect is completely ambiguous
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