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

Question

BlackTom AI · Accepted Answer

In the Mundell–Fleming framework for a small open economy with floating exchange rates, expansionary fiscal policy is weakened because currency appreciation reduces net exports.

1) Relevant knowledge points and concepts
- Mundell–Fleming model: fiscal expansion shifts the IS curve right.
- With high capital mobility and floating exchange rates, a fiscal expansion raises domestic interest rates relative to the world rate, attracting capital inflows.
- Capital inflows cause the domestic currency to appreciate; an appreciation makes exports cheaper for foreigners and imports cheaper for residents in domestic-currency terms, so net exports (NX = exports − imports) fall.
- The fall in NX partially or fully offsets the initial demand stimulus from higher government spending, weakening the fiscal multiplier.

2) Step-by-step reasoning
- Increase in government spending (ΔG > 0) initially raises aggregate demand and output.
- Higher output tends to raise domestic interest rates (or at least creates a gap with the world rate), which induces capital inflows under open capital accounts.
- Capital inflows increase demand for the domestic currency, causing an appreciation of the exchange rate.
- Appreciation reduces exports and increases imports ⇒ NX declines.
- The decline in NX subtracts from aggregate demand, offsetting some of the effect of ΔG and thus weakening the net impact on output.

3) Intermediate steps (symbolic illustration)
- Initial fiscal multiplier (closed-economy intuition): ΔY_initial = (1/(1 − c))·ΔG (c = MPC).
- Exchange-rate response: Δe ↑ as a function of capital inflow driven by Δr.
- Net export response: ΔNX = −m·Δe (m > 0 indicates NX falls when currency appreciates).
- Net output change: ΔY_net = (1/(1 − c))·(ΔG + ΔNX) = (1/(1 − c))·(ΔG − m·Δe) < (1/(1 − c))·ΔG.
Thus appreciation reduces the effective multiplier.

4) Why the correct answer is correct
Because appreciation caused by capital inflows directly reduces net exports, it counteracts the increase in demand from fiscal expansion. That mechanism weakens, rather than strengthens, fiscal policy under floating exchange rates.

5) Why other options are incorrect
- “Weakened due to the impossible trinity.” The impossible trinity is about policy trade-offs between fixed exchange rates, monetary independence, and capital mobility; it does not directly explain the appreciation/exports channel that weakens fiscal policy under floating rates.
- “Strengthened an appreciation ... counteract the potential for crowding out.” An appreciation would not counteract crowding out; it intensifies it by reducing NX.
- “Strengthened because a depreciation ... exports rise and imports fall.” Fiscal expansion under floating rates typically leads to appreciation (not depreciation), so this strengthens neither the logic nor the outcome.

6) Conclusion
The correct answer is weakened because an appreciation of the currency many also cause exports to fall and imports to rise, which matches the provided answer.

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

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