Final answer:
Increasing the money supply in a small open economy leads to a depreciation of the currency and an increase in economic activity according to the Mundell-Fleming model, while the impact on goods and services can be estimated using the quantity theory of money.
Step-by-step explanation:
When the central bank increases the money supply, it typically does so through open market operations, such as purchasing government bonds from banks like Happy Bank. This increase in reserves prompts banks to issue more loans, increasing the money supply further through the money multiplier effect.
The Mundell-Fleming model with floating exchange rates suggests that the increased money supply will lead to a depreciation of the exchange rate, stimulating exports and reducing imports, which in turn boosts aggregate demand and economic activity in a small open economy.
Additionally, the quantity theory of money, MV = PY, where M is the money supply, V is the velocity, P is the price level, and Y is the real output, can be used to calculate the impact on the economy. If the velocity of money and the price level changes are known, as given in the scenario, we can estimate the change in the quantity of goods and services produced as a result of an increase in the money supply.