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

Question

BlackTom AI · Accepted Answer

In the Mundell–Fleming model with a floating exchange rate, expansionary monetary policy depreciates the currency, which raises net exports and thus strengthens the policy’s effect on output. 1) Relevant knowledge points and concepts - Expansionary monetary policy: increasing the money supply or lowering the domestic interest rate. - Floating exchange rate: exchange rate is market-determined and adjusts to capital flows and interest differentials. - Open-economy transmission (Mundell–Fleming): with perfect capital mobility, a lower domestic interest rate leads to capital outflows and currency depreciation; depreciation raises net exports (exports up, imports down), increasing aggregate demand and output. - Impossible trinity (trilemma): a country cannot simultaneously have a fixed exchange rate, free capital mobility, and independent monetary policy. With a floating rate, independent monetary policy is feasible. 2) Step-by-step reasoning - Central bank increases money supply → domestic interest rate falls. - Lower interest rate makes domestic assets less attractive → capital flows out → pressure for the currency to depreciate. - Currency depreciation makes domestic goods cheaper for foreigners and foreign goods more expensive for residents → exports rise, imports fall → net exports increase. - Increased net exports shift aggregate demand/IS curve right, reinforcing the original expansionary effect on output. 3) Intermediate steps (illustrative) - ΔM > 0 → Δi < 0. - Δi < 0 → capital outflow → Δe (domestic currency) < 0 (depreciation). - Δe < 0 → ΔNX > 0 → additional ΔY > 0. 4) Why the correct answer is correct Because the depreciation induced by monetary expansion raises net exports, it amplifies (strengthens) the output boost from monetary policy under floating exchange rates. The phrase “may also cause exports to rise and imports to fall” captures this reinforcing channel. 5) Why other options are incorrect - “Strengthened an appreciation ... counteract crowding out.” Incorrect: monetary expansion typically causes depreciation, not appreciation; crowding out is primarily a fiscal phenomenon and not the relevant counterforce here. - “Weakened due to the impossible trinity.” Incorrect: the trilemma does not weaken monetary policy under a floating rate; independence of monetary policy is possible with a floating exchange rate. - “Weakened because an appreciation ... exports fall and imports rise.” Incorrect sign: expansionary monetary policy causes depreciation, not appreciation. 6) Conclusion Therefore, expansionary monetary policy in an open economy with a floating exchange rate is strengthened because a depreciation of the currency may also cause exports to rise and imports to fall, which matches the provided answer.

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