1. lower output in both countries when the exchange rate is fixed.
2. raise output in the small country when the exchange rate is flexible.
3. do both of the above.
4. do neither of the above.
Choose the correct option.
The correct answer is option 1. A monetary contraction in the big country will result in an increase in the world interest rate and cause that country's output to decline. Under a fixed exchange rate regime equilibrium in the small country will occur at the intersection of the IS curve and the real interest rate line. Small-country output will therefore fall. Under a flexible exchange rate regime equilibrium will occur at the intersection of the LM curve and the real interest rate line. If the small country's central bank does not contract the money supply to prevent employment from increasing above its normal full-employment level real output will increase. If the small country authorities manage the float, however, that country's output need not increase.