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

Question

BlackTom AI · Accepted Answer

Under a fixed exchange rate and perfect capital mobility, expansionary fiscal policy is strengthened because the central bank’s exchange-rate defense prevents the normal interest-rate appreciation that would crowd out net exports.

1) Relevant concepts:
- Mundell–Fleming model for an open economy with fixed exchange rates and high capital mobility.
- Interaction of IS (goods market), LM (money market) and balance-of-payments: fiscal expansion shifts IS right.
- With fixed exchange rates, the central bank intervenes in foreign-exchange markets to maintain the peg, altering the domestic money supply endogenously.

2) Step-by-step reasoning:
- The government raises spending (or cuts taxes) → aggregate demand increases → IS curve shifts right → output tends to rise and domestic interest rate tends to increase.
- A domestic interest rate above the world rate induces capital inflows, putting upward pressure on the domestic currency (an appreciation).
- To keep the exchange rate fixed, the central bank buys foreign currency and sells domestic currency (i.e., increases the domestic money supply).
- The increase in money supply shifts LM right, which lowers the interest rate back to the world level and further increases output.
- Because the central bank’s intervention neutralizes the interest-rate rise, there is no monetary crowding-out of investment and no appreciation-induced reduction in net exports. Fiscal expansion is therefore reinforced.

3) Intermediate “calculations”/shifts (qualitative):
- Initial: IS0, LM0 intersect at (Y0, r0).
- Fiscal: IS0 → IS1 → pushes r up to r1 and Y to Y1.
- FX intervention: central bank increases money supply → LM0 → LM1 → new equilibrium at higher Y2 with r returning to r0 (world rate).

4) Why the correct answer is correct:
The central bank’s foreign-exchange purchases to prevent appreciation increase the domestic money supply, offsetting any rise in interest rates and eliminating crowding out, thereby strengthening fiscal policy.

5) Why other options are incorrect:
- Option 1 misstates the mechanism: interventions to prevent appreciation do not directly “cause exports to rise and imports to fall” (indeed appreciation would lower exports); the key is preventing appreciation and crowding out, not mechanically reversing trade flows.
- Option 2 is wrong because it describes counteracting a depreciation; the relevant pressure from fiscal expansion is appreciation, not depreciation.
- Option 3 invokes the impossible trinity incorrectly: the trilemma describes trade-offs in policy choices, but it does not imply fiscal expansion is weakened under a fixed peg—monetary accommodation by the central bank actually strengthens fiscal policy.

6) Conclusion:
Therefore 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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