In a small open economy with a floating exchange rate, the exchange rate will appreciate if:
A) the money supply is increased.
B) the money supply is decreased.
C) government spending is decreased.
D) taxes are increased.

Question

Quizplus · Accepted Answer

When the money supply is decreased, it will decrease the demand for local currency, leading to an appreciation of the exchange rate. A decrease in government spending or an increase in taxes will both lead to a decrease in aggregate demand, which may lead to a decrease in money supply or an increase in savings, but will not directly affect the exchange rate. Therefore, the correct option is B.

In a Small Open Economy with a Floating Exchange Rate