Expansionary monetary policy in an open economy with a floating exchange rate is:

Question

BlackTom AI · Accepted Answer

Expansionary monetary policy increases the money supply, which lowers domestic interest rates and, in a floating exchange rate system, leads to currency depreciation that boosts net exports.

1. Relevant knowledge points and concepts
- Mundell–Fleming model for an open economy with a floating exchange rate: monetary policy shifts the LM curve and changes interest rates.
- Interest parity and capital flows: lower domestic interest rates induce capital outflows, putting downward pressure on the currency.
- Net exports and the exchange rate: a depreciation makes exports cheaper and imports more expensive, raising net exports (subject to the Marshall–Lerner condition).

2. Step-by-step reasoning
- Step 1: Central bank increases money supply (expansionary monetary policy).
- Step 2: Increased money supply shifts LM (or equivalent) right, reducing the domestic nominal and real interest rates.
- Step 3: Lower interest rates make domestic assets less attractive, causing capital outflows under free capital mobility.
- Step 4: Capital outflows cause the domestic currency to depreciate in a floating-rate regime.
- Step 5: Depreciation raises the foreign-currency price of imports and lowers the domestic-currency price of exports, increasing net exports.
- Step 6: Higher net exports further raise aggregate demand and output, reinforcing the initial monetary stimulus.

3. Intermediate reasoning/calculation steps
- No numeric values are required, but the causal chain is: ΔM > 0 → i ↓ → capital outflow → E depreciates → NX ↑ → Y ↑. Each arrow is driven by the mechanisms above (money market adjustment, interest parity, and trade price effects).

4. Why the correct answer is correct
- Because the floating exchange rate allows the exchange rate to move and amplify the monetary expansion through improved net exports. The depreciation acts as an additional channel increasing aggregate demand beyond the closed-economy effect.

5. Why other options would be incorrect
- “Neutralized”: would be true under a fixed exchange rate (where the central bank must offset flows to maintain the peg), not under floating rates.
- “Weakened”: incorrect because depreciation under floating rates works in the same direction as monetary expansion, not against it.

6. Conclusion
The correct answer is: "strengthened because a depreciation of the currency many also cause exports to rise and imports to fall." This matches the provided answer.

Expansionary monetary policy in an open economy with a floating exchange rate is:Single choice

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