Question

Scenario 2

East Bubble's main trading partner is West Bubble. East Bubble has fixed its exchange rate with West Bubble. To fight inflation, West Bubble undertakes a contractionary monetary policy. Consider what happens if East Bubble uses monetary policy to maintain the exchange rate equal to its fundamental value.
(Refer to the Scenario 2) In the short-run equilibrium, the policies of both countries combined cause East Bubble's output to exports to_______ and its real exchange rate to_____
its real exchange rate to_____
a. increase; decrease; increase
b. increase; increase; increase
c. decrease; be ambiguous; decrease
d. decrease; be ambiguous; remain unchanged
e. decrease, decrease; remain unchanged

Answer 1

In the short-run equilibrium, East Bubble's output is likely to decrease and its real exchange rate will decrease as well.

Step-by-step explanation:

In this scenario, East Bubble's main trading partner is West Bubble, and they have fixed exchange rates. When West Bubble employs a contractionary monetary policy to fight inflation, it will cause its currency to appreciate. As a result, the exports from East Bubble will decrease because foreign buyers will find them more expensive. The real exchange rate of East Bubble will also decrease due to the appreciation of West Bubble's currency.

Since West Bubble is implementing a contractionary monetary policy, it is aiming to reduce inflation. This policy will lead to a decrease in West Bubble's demand for goods and services, including those from East Bubble. As a result, East Bubble's output of exports will decrease. So, in the short-run equilibrium, East Bubble's output is likely to decrease and its real exchange rate will decrease as well.