Question

In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the process of adjusting to the new short-run equilibrium, the money supply:
a. increases to keep the exchange rate unchanged, thus augmenting the effect of government spending on income.
b. decreases to keep the exchange rate unchanged, thus offsetting the effect of government spending on income.
c. remains unchanged, and there is no effect of government spending on income.
d. remains unchanged to keep the interest rate at the world interest rate, so that government spending reduces income.

Answer 1

Answer:

The correct option here is A) .

Explanation:

In the given small open economy , if government increase the government purchases than people in the economy will have more or increased money supply, so when the rates are fixed , in the short run , the income will rise with exchange rates remaining same. Thus option A is definitely correct as money supply would be increased to keep exchange rates fixed and augmenting the effects of government spending on income.