Monetary and Supply-Side Policy: Question 7

Worked solution

Step 1: Recall that the exchange rate is a monetary policy instrument

Monetary policy works through three instruments: the interest rate, the money supply, and the exchange rate. Here, Verdanto’s central bank chooses to act through the exchange rate directly, rather than by changing the interest rate, deliberately allowing the Verdanto dollar to fall in value against other currencies, a depreciation.

Step 2: Trace the direct effect of a depreciation on trade

When a currency depreciates:

• Foreign buyers need less of their own currency to buy Verdanto’s exports, so Verdanto’s exports become cheaper abroad.
• Verdanto’s residents and firms need more Verdanto dollars to buy the same quantity of foreign goods, so imports become more expensive.

Cheaper exports should make Verdanto’s goods more attractive to foreign buyers, raising demand for exports; more expensive imports should make domestically produced goods relatively more attractive to buyers at home. Both effects tend to raise demand for Verdanto’s own output, which can increase output, support economic growth and help reduce unemployment.

Step 3: Why the other options are wrong

• B: This reverses the true direction of the price effect. A depreciation makes exports cheaper and imports dearer, not the other way round.
• C: A depreciation makes imported goods and materials more expensive, not cheaper, so it raises rather than lowers firms’ import costs. Indeed, this is a possible drawback of the policy, since costlier imports can add to inflation even as growth is supported.
• D: The exchange rate is a distinct monetary policy tool that directly changes the price of exports and imports; it is not simply a way of changing government spending, which is a fiscal policy matter.

Final answer

The most likely direct effect is that Verdanto’s exports become cheaper and its imports become more expensive, option A.