1. only when the nominal exchange rate is flexible.
2. regardless of whether the nominal exchange rate is fixed or flexible.
3. only when the nominal exchange rate is flexible and the small country's nominal money supply is held constant.
4. only when the nominal exchange rate is flexible and the small country's real money supply is held constant.
Choose the correct option.
Option 2 is the only one that produces a correct result. A positive real shock in the big country will shift the world real interest rate upward. Under a flexible exchange rate, output in the small country must rise (or remain unchanged if the country successfully adopts managed floating). The IS curve must shift upward, and the only way this can happen is through a depreciation of the real exchange rate. Under a fixed exchange rate, a depreciation does not occur in the short run, but it will necessarily occur in the long run since the IS curve has to shift up to cross the vertical full-employment line at the higher world real rate of interest.