Answer:
Consider the following explanation
Explanation:
Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the economy supply means an increase in real balances. The increase in real balances shifts the LM* curve to right. Hence, an increase in the money supply raises income and lowers the exchange rate.
Although monetary policy influences income in an open economy, as it does in a closed economy an increase in the money supply increases spending because it loweres the interest rate and stimulates investment. In a small open economy the interest rate is fixed by the world interest rate. as soon as an increase in the money supply puts downward pressure on the domestic interest rate, capital flows out of the economy as investors seek a higher return elsewhere.
This capital outflow prevents the domestic interest rate from falling. In addition, because the capital outflow increases the supply of domestic currency in the market for foreign currency exchange , the exchange rate depreciates. The fall in the exchange rate makes domestic goods inexpensive relative to foreign goods and thereby, stimlates net exports. Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate.
Expansionary monetary policy in fixed exchange rate -
Imagine that a central bank operating with a fixed exchange rate were to try increase the money supply - for example, by buying bonds from the public. The initial impact of this policy is to shift the LM* curve to the right lowering the exchange raate. But bexcause the central bank is committed to trding foreign and domestic currency at a fixed exchangerate., arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank, causing the money supply and the LM* curve to return to their initial position. Hence, monetary policy as usually conducted is inefficient under a fixed exchange rate.
A country with fixed exchange rate can however, conduct a type of monetary policy - it can decide to change the level at which the exchange rate is fixed. A reduction in the value of currency is called devaluation, and an increase in its value is revaluation.
