Question

Microeconomics

Posted 3 months ago

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Assuming there is no change in the nominal exchange rate, what will be the effect of contractionary monetary policy in Canada on the Canadian price level and the real exchange rate (RER) of the Canadian dollar?
Choose 1 answer:
A Price level will decrease; RER will remain unchanged.
B Price level will decrease; RER will increase.
(C) Price level will decrease; RER will decrease.
D Price level will increase; RER will increase.
(E) Price level will increase; RER will decrease.
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Answer from Sia

Posted 3 months ago

Solution

a

Contractionary Monetary Policy: Contractionary monetary policy involves reducing the money supply or increasing interest rates to curb inflation. This typically leads to a decrease in the price level

b

Real Exchange Rate (RER): The real exchange rate is given by the formula $RER = \frac{eP}{P^*}$, where $e$ is the nominal exchange rate, $P$ is the domestic price level, and $P^*$ is the foreign price level

c

Effect on Price Level: With contractionary monetary policy, the domestic price level ($P$) decreases

d

Effect on RER: Since the nominal exchange rate ($e$) is assumed to be unchanged and the domestic price level ($P$) decreases, the real exchange rate ($RER$) will increase because $RER = \frac{eP}{P^*}$ and $P$ is in the numerator

Answer

B Price level will decrease; RER will increase.

Key Concept

Contractionary monetary policy decreases the price level and increases the real exchange rate.

Explanation

Contractionary monetary policy reduces the money supply, leading to a decrease in the domestic price level. Given that the nominal exchange rate remains unchanged, the real exchange rate increases as the domestic price level falls.

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