1. letting the exchange rate float and imposing an appropriate monetary expansion.
2. keeping the exchange rate fixed and applying an appropriate subsidy to exports.
3. both of the above.
4. neither of the above.
Choose the option above that is correct.
The right answer is option 3. The tariff operates on output and employment by increasing the current account balance and shifting IS to the right. An endogenous increase in the money supply then brings about an equivalent rightward shift of the LM curve. An equivalent increase in the current account balance can be brought about by subsidizing exports instead of taxing imports. And the same result can be achieved by letting the exchange rate float and using monetary expansion to shift the LM curve to the right until the desired level of output and employment is achieved. In this case the domestic currency will depreciate to shift IS to the right by the same amount as the monetary expansion shifted the LM curve.