In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new short-run equilibrium the IS* curve shifts to the right, raising the exchange rate:
A)but not raising net exports or income.
B)and net exports but not income.
C)and income but not net exports.
D)net exports and income.

Question

Quizplus · Accepted Answer

In a small open economy with a floating exchange rate, an import quota reduces imports, which initially increases net exports. However, the higher exchange rate that results from the rightward shift of the IS* curve offsets this by making exports more expensive and imports cheaper, leaving net exports and income unchanged in the new short-run equilibrium.

In a Small Open Economy with a Floating Exchange Rate