In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the process of adjusting to the new short-run equilibrium the money supply:
A) increases to keep the exchange rate unchanged, thus augmenting the effect of government spending on income.
B) decreases to keep the exchange rate unchanged, thus offsetting the effect of government spending on income.
C) remains unchanged, and there is no effect of government spending on income.
D) remains unchanged to keep the interest rate at the world interest rate, so that government spending reduces income.

Question

Quizplus · Accepted Answer

In a small open economy with a fixed exchange rate, an increase in government purchases will increase the demand for goods and services, leading to an increase in income. However, since the exchange rate is fixed, the increase in income leads to an increase in demand for foreign currency, causing the domestic currency to depreciate. To prevent this depreciation, the central bank must increase the money supply by buying domestic currency and selling foreign currency, thus keeping the exchange rate fixed. This increase in the money supply will further augment the effect of government spending on income. Therefore, choice A is the correct answer.

In a Small Open Economy with a Fixed Exchange Rate