Question

Monetary policy under flexible exchange rates

a. How does a monetary expansion in an economy with flexible exchange rates affect

consumption and investment?

b. How does a monetary expansion in an economy with flexible exchange rates affect net

exports?

Answer 1

a) A monetary expansion increases liquidity in the market where bank reserves are increased. This implies lower interest rates and so consumption and investment are increased. This happens because interest rate, the cost of borrowing, falls so borrowing by households and firms increases.

b) By making available more currency than desired, the value of currency falls. This is in relation with its value with the other currency so that domestic currency depreciates. Now with depreciated currenct, exports are increased as they are cheaper. Imports are expensive. Net exports are increased.