Question

A contractionary monetary policy causes

group of answer choices
A. higher interest rates, which increases the international price of the dollar and decreases net exports.
B. higher interest rates, which decreases the foreign demand for u.s. financial instruments, raising the international price of the dollar and increasing net exports
C. lower interest rates, which decreases the foreign demand for u.s. financial instruments, raising the international price of the dollar and increasing net exports
D. higher interest rates, which increases the foreign demand for u.s. financial instruments, which causes interest rates to decrease.
E. there is no effect on net exports.

Answer 1

A contractionary monetary policy causes the currency to appreciate, reduces exports, and causes a decrease in GDP.

Step-by-step explanation:

A contractionary monetary policy, by driving up domestic interest rates, would cause the currency to appreciate. The higher value of the currency in foreign exchange markets would reduce exports, since from the perspective of foreign buyers, they are now more expensive.

The higher value of the currency would similarly stimulate imports, since they would now be cheaper from the perspective of domestic buyers. Lower exports and higher imports cause net exports (EX - IM) to fall, which causes aggregate demand to fall. The result would be a decrease in GDP working through the exchange rate mechanism reinforcing the effect contractionary monetary policy has on domestic investment expenditure.

However, cheaper imports would stimulate aggregate supply, bringing GDP back to potential, though at a lower price level.