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

Question

BlackTom AI · Accepted Answer

In the Mundell–Fleming model for a small open economy with floating exchange rates, expansionary monetary policy is strengthened because a depreciation of the currency many also cause exports to rise and imports to fall.

1) Relevant knowledge points and concepts
- Mundell–Fleming (IS-LM for open economies): with perfect capital mobility, fiscal policy is less effective under floating rates, while monetary policy is effective.
- Transmission mechanism: money supply → interest rate → capital flows → exchange rate → net exports → output.
- Impossible trinity (trilemma): a country cannot simultaneously have fixed exchange rates, free capital mobility, and independent monetary policy. Floating rates preserve monetary autonomy.

2) Step-by-step reasoning process
- Step 1: The central bank increases the nominal money supply (expansionary monetary policy).
- Step 2: Higher money supply lowers domestic interest rates (liquidity effect).
- Step 3: Lower domestic interest rates relative to world rates cause capital outflows (capital seeks higher returns abroad).
- Step 4: Capital outflows put downward pressure on the domestic currency, causing depreciation.
- Step 5: Depreciation makes domestic goods cheaper to foreigners and foreign goods more expensive to residents, increasing exports and reducing imports.
- Step 6: Higher net exports shift aggregate demand upward, raising output and further reinforcing the initial monetary stimulus.

3) Intermediate steps (no numeric calculations here)
- ΔM↑ → i↓
- i↓ → capital outflow → exchange rate depreciates (E↑ in price of domestic currency)
- depreciation → NX↑ → Y↑

4) Why the correct answer is correct
Because under floating exchange rates the exchange-rate channel amplifies monetary policy: depreciation raises net exports, so the initial increase in money supply not only raises demand through lower rates but is reinforced by improved external demand.

5) Why the other options are incorrect
- Option 2 (strengthened an appreciation counteract crowding out): incorrect sign — expansionary money leads to depreciation, not appreciation; crowding out is a fiscal concept.
- Option 3 (weakened due to the impossible trinity): incorrect application — the trilemma says floating rates allow independent monetary policy, so policy is not weakened here.
- Option 4 (weakened because an appreciation causes exports to fall): incorrect because expansionary monetary policy induces depreciation, not appreciation; the stated mechanism would weaken policy but does not apply.

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

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

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