Question

How would a decrease in the money supply of Paraguay (currency unit: the guaraní) affect its own output and its exchange rate with Brazil (currency unit: the real). Do you think this policy in Paraguay might also affect output across the border in Brazil? Explain.

*Please use a diagram*

Answer 1

A decrease in the real money supply leads to a leftward shift in the LM curve. This leads to a decrease in Paraguay’s output, an increase in Paraguay’s interest rates, and an appreciation in the guaraní. This is illustrated in the following figure. This could affect output in Brazil through the trade balance. First, because Paraguay’s income is lower, Brazil’s exports could decline. Second, because the real has depreciated relative to the guaraní, this may make Brazilian exports more attractive to foreigners, potentially boosting Brazil’s trade balance. The overall effects on Brazil’s trade balance and its output are ambiguous. At the same time, Brazil’s economy is over 15 times the size of Paraguay’s. Therefore, the impact of a change in Paraguay’s monetary policy on Brazil’s economy is likely to be small.