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 a floating exchange rate, expansionary fiscal policy has a limited net effect because exchange rate movements offset part of the stimulus.

1. Relevant knowledge points and concepts
- IS-LM-BP (Mundell–Fleming) model: fiscal expansion (↑G or ↓T) shifts the IS curve right, raising output and domestic interest rates.
- Under floating exchange rates with open capital markets, higher domestic interest rates attract capital inflows, causing the domestic currency to appreciate.
- Appreciation lowers net exports (NX = Exports − Imports) by making exports more expensive and imports cheaper, reducing aggregate demand.
- The policy trilemma (impossible trinity) is related but not the operative mechanism here.

2. Step-by-step reasoning process
- Step 1: Government increases spending → aggregate demand rises → IS shifts right → initial rise in output and interest rate.
- Step 2: Higher interest rate vs. world rate induces capital inflows (financial account surplus).
- Step 3: Floating exchange rate responds: increased demand for domestic currency causes currency appreciation.
- Step 4: Appreciation makes domestic goods relatively more expensive abroad and foreign goods cheaper domestically → exports fall, imports rise → NX declines.
- Step 5: The decline in NX offsets part of the initial increase in aggregate demand from fiscal expansion, weakening the net expansionary effect on output.

3. Intermediate steps/calculations
- In functional form: Y = C(Y − T) + I(r) + G + NX(e). Fiscal ↑G raises Y, raises r, which through capital flows raises exchange rate e (appreciation), lowering NX(e), partly offsetting ΔY.

4. Why the correct answer is correct
- The reasoning above shows appreciation mechanically reduces net exports and thus offsets fiscal stimulus; hence expansionary fiscal policy is weakened.

5. Why other options are incorrect
- Option A (strengthened due to depreciation): fiscal expansion typically causes appreciation, not depreciation, under floating rates.
- Option B (weakened due to the impossible trinity): the trilemma is a broader constraint and does not directly explain the offset via appreciation.
- Option C (strengthened because appreciation counteracts crowding out): appreciation causes a contraction in NX, which reinforces crowding out rather than counteracting it.

6. Conclusion
The correct choice is: "weakened because an appreciation of the currency many also cause exports to fall and imports to rise." This matches the provided answer.

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

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