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    Question

    In the Mundell-Fleming model with a floating exchange rate and perfect capital mobility, what is the effect of an increase in the money supply?

    A The domestic currency appreciates, and output decreases. Correct Answer Incorrect Answer
    B The domestic currency depreciates, and output increases Correct Answer Incorrect Answer
    C The domestic currency appreciates, and output increases Correct Answer Incorrect Answer
    D The domestic currency depreciates, and output decreases. Correct Answer Incorrect Answer

    Solution

    Under a floating exchange rate with perfect capital mobility, an increase in the money supply shifts the LM curve to the right, reducing the interest rate. This leads to capital outflows, causing the domestic currency to depreciate. The depreciation makes domestic goods cheaper for foreigners, increasing net exports and thus increasing output.

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