Answer to Question #92617 in Macroeconomics for Nes

Question

Explain briefly why a monetary contraction for a small open economy under fixed exchange rates will have no effect on real income.

Answer 1

Monetary contraction causes LM curve to shift to the left relative to initial equilibrium. This results in an equilibrium at higher domestic interest than foreign interest given fixed IS curve. As a result higher capital flows into the country increasing demand for local currency hence appreciation in value. The central bank responds by buying foreign currency and selling local currency in order to maintain exchange rate. This causes the LM curve to move to the right to the initial equilibrium maintaining the initial domestic economy