Expansionary fiscal policy in an open economy with a fixed exchange rate will likely:

Question

BlackTom AI · Accepted Answer

In the Mundell–Fleming framework for an open economy with a fixed exchange rate, fiscal expansion tends to worsen the trade balance by increasing imports and reducing exports.

1) Relevant concepts:
- IS-LM-BP (Mundell–Fleming) for an open economy with perfect capital mobility and a fixed exchange rate.
- Under a fixed peg, the central bank intervenes in foreign exchange markets to keep the exchange rate constant, adjusting the domestic money supply as needed.
- Net exports = exports − imports; imports rise with higher domestic income, exports depend on foreign demand and relative competitiveness.

2) Step-by-step reasoning:
- A fiscal expansion (higher G or lower taxes) shifts the IS curve right, raising aggregate demand and domestic output (Y).
- The initial higher Y would put upward pressure on domestic interest rates, attracting capital inflows. Under a fixed exchange rate the central bank prevents currency appreciation by buying foreign currency and selling domestic currency.
- That intervention increases the domestic money supply (shifts LM right), which supports even higher output while keeping the exchange rate fixed and the interest rate tied to the world rate.
- The higher domestic income raises import demand (M = mY for some import propensity m), so imports increase substantially.
- Exports are determined mainly by foreign income and relative prices. The monetary expansion and subsequent domestic demand-driven inflationary pressures reduce domestic competitiveness over time, and the stronger money supply/price response lowers net foreign competitiveness, causing exports to fall (or at least not rise). Overall net exports decline.

3) Intermediate/quantitative intuition:
- If ΔY > 0 from fiscal policy and imports are proportional to Y, ΔM = m·ΔY > 0.
- Central bank intervention ΔMS > 0 to maintain peg; this tends to reduce competitiveness and thus reduces X in the medium run.

4) Why the correct answer is correct:
- Fiscal expansion raises domestic income → imports rise.
- With a fixed peg and accommodating monetary intervention, competitiveness and relative price effects cause exports to fall, so exports are lower while imports are higher.

5) Why the other options are incorrect:
- "Raise exports and lower imports": contradicts the direct effect of higher domestic income increasing imports; exports do not rise because foreign demand and competitiveness do not improve.
- "Not change exports and imports": wrong because imports clearly increase with higher domestic income, and export competitiveness tends to worsen or fall.

Conclusion: Expansionary fiscal policy in an open economy with a fixed exchange rate will likely lower exports and raise imports, which matches the provided answer.

Expansionary fiscal policy in an open economy with a fixed exchange rate will likely:Single choice

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