Contractionary monetary policy in an open economy with a floating exchange rate will likely ____ a trade surplus.

Question

BlackTom AI · Accepted Answer

Contractionary monetary policy raises domestic interest rates and causes the currency to appreciate under a floating exchange rate, so it reduces a trade surplus.

1. Relevant knowledge points and concepts
- Monetary contraction: a decrease in the money supply (or tighter monetary policy) tends to raise domestic interest rates.
- Floating exchange rate: the exchange rate moves freely in response to capital flows and interest rate differentials.
- Capital mobility: higher domestic interest rates attract foreign capital, causing upward pressure on the domestic currency.
- Net exports and trade balance: an appreciated domestic currency makes exports more expensive and imports cheaper, reducing net exports and therefore shrinking a trade surplus.
- Mundell–Fleming (open-economy IS–LM) intuition: with a floating rate and high capital mobility, monetary policy affects the interest rate and exchange rate, which alters net exports.

2. Step-by-step reasoning
- Step 1: Contractionary monetary policy → money supply falls.
- Step 2: Lower money supply → higher domestic interest rate (to equilibrate money market).
- Step 3: Higher interest rate → capital inflows as foreign investors seek higher returns.
- Step 4: Capital inflows → appreciation of the domestic currency under a floating exchange rate.
- Step 5: Appreciation → exports become relatively more expensive and imports cheaper.
- Step 6: Net exports (exports − imports) decrease → trade surplus declines.

3. Intermediate relationships (qualitative calculations)
- M ↓ ⇒ r ↑
- r ↑ ⇒ capital inflow ↑ ⇒ exchange rate appreciates
- appreciation ⇒ X ↓ and IM ↑ ⇒ NX = X − IM ↓

4. Why the correct answer is correct
The chain from monetary contraction to higher interest rates to currency appreciation directly reduces net exports; if the economy initially had a trade surplus, that surplus will shrink. This outcome is the standard result in open-economy macroeconomics with floating exchange rates.

5. Why the other options are incorrect
- "Not change": incorrect because a floating exchange rate transmits monetary shocks into exchange rate movements that alter net exports, so the trade balance does change.
- "Worsen": as a distractor, it is ambiguous; the intended precise effect is a reduction in the surplus, which is captured by "reduce." The mechanism produces a smaller surplus, not a neutral outcome.

6. Conclusion
The correct outcome is that contractionary monetary policy in an open economy with a floating exchange rate will reduce a trade surplus, matching the provided answer: reduce.

Contractionary monetary policy in an open economy with a floating exchange rate will likely ____ a trade surplus.单项选择题

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