Question

In order to try to fight the impact of the COVID-19 outbreak, the U.S. has implemented expansionary monetary policy. Using both words and figures, explain how this policy affects the real exchange rate and trade position of a small open economy, such as Sweden. Assume that this small open economy was not directly affected by the outbreak.

Answer 1

Ans. An expansionary monetary policy in US leads to increase in money supply which causes a condition of excess supply in the market for given money demand causing the interest rate to fall. This fall in interest rate increases met capital outflow decreasing the demand for US dollar leading to its depreciation.

In Sweden, due to depreciation of US dollar and because Sweden is not directly affected by COVID, its currency, Swedish Krona, appreciates (from e to e’) making exports from Sweden expensive, decreasing their demand, but imports cheaper increasing their demand leading to fall in net exports. Thus, current account deficit increases.

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