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

Question

BlackTom AI · Accepted Answer

Expansionary fiscal policy raises aggregate demand, which tends to increase output and push up domestic interest rates. In a fixed-exchange-rate open economy with capital mobility, the higher domestic rate attracts capital inflows and puts upward pressure on the currency (appreciation). To maintain the fixed parity, the central bank intervenes by buying foreign currency and selling domestic currency; this intervention increases the domestic money supply.

Step-by-step reasoning:
1. Fiscal expansion (ΔG > 0 or ΔT < 0) shifts IS right → initial ΔY > 0 and Δi > 0.
2. Higher i attracts foreign capital → pressure for currency appreciation.
3. Under a fixed rate, the central bank must prevent appreciation by purchasing foreign exchange and selling domestic currency.
4. These purchases increase domestic monetary base and money supply (ΔMs > 0), shifting LM right.
5. The monetary expansion lowers interest rates back toward their original level, offsetting the fiscal-induced rise in i. That eliminates or reduces crowding out of investment.
6. With no rise in i and a larger money supply, output rises more than it would under a floating rate (the fiscal multiplier is larger).

Why the correct choice is correct:
Because central-bank intervention to maintain the peg converts part of the fiscal stimulus into an accommodated monetary expansion, it counteracts the usual crowding-out channel (higher i reducing investment). Thus fiscal policy is strengthened under a fixed exchange rate.

Why other options are incorrect:
- Option 1: Misstates the mechanism. The key strengthening effect comes from preventing crowding out via an expanded money supply, not primarily from exports rising and imports falling; in fact, preventing appreciation mainly preserves net exports rather than causing large export increases.
- Option 2: Describes depreciation effects, which is the opposite pressure generated by capital outflows, not relevant here.
- Option 3: Invokes the "impossible trinity" incorrectly; the trilemma constrains independent monetary policy under free capital flows and fixed rates, but it does not make fiscal expansion weaker—instead monetary accommodation by the central bank strengthens fiscal effects here.

Conclusion: Expansionary fiscal policy in an open economy with a fixed exchange rate is strengthened because the government’s actions to counteract an appreciation of the currency also counteract the potential for crowding out. This matches the provided answer.

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

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