Expansionary fiscal policy in an open economy with a floating exchange rate will likely ____ a trade deficit.

Question

BlackTom AI · Accepted Answer

Expansionary fiscal policy raises government spending or lowers taxes, increasing aggregate demand and shifting the IS curve outward in an open-economy macro model.

Relevant concepts:
- Mundell–Fleming (open-economy IS-LM) with a floating exchange rate.
- Interest rate–capital flow link: higher domestic interest rates attract foreign capital.
- Exchange-rate adjustment: capital inflows cause domestic currency appreciation.
- Net exports (NX = exports − imports) respond negatively to currency appreciation.

Step-by-step reasoning:
1. Fiscal expansion (↑G or ↓T) raises planned expenditure and output at each interest rate, shifting IS rightward and increasing equilibrium output.
2. With money supply unchanged, higher output raises the demand for money; the interest rate must rise to equilibrate money markets (LM unchanged), so the domestic interest rate increases.
3. Higher domestic interest rates attract foreign capital (capital inflows), creating upward pressure on the domestic currency under a floating exchange rate.
4. The domestic currency appreciates in real and nominal terms, making domestic goods more expensive for foreigners and foreign goods cheaper for domestic residents.
5. Exports fall and imports rise, so net exports decline (NX decreases). Since the trade balance = NX, the trade deficit worsens.

Why the correct answer is “worsen”:
Appreciation induced by fiscal expansion reduces net exports, therefore increasing the trade deficit under a floating exchange rate. This is the standard Mundell–Fleming result for expansionary fiscal policy with perfect or high capital mobility.

Why other outcomes are incorrect:
- “Improve” would require net exports to rise, but appreciation cuts exports and raises imports, so improvement is unlikely under floating rates.
- “No change” would occur only if other policies (e.g., offsetting monetary expansion) or exceptional elasticities occur; it is not the typical outcome.
- “Ambiguous” ignores the standard mechanism above; ambiguity arises only under special assumptions (e.g., very small capital mobility or offsetting policy).

Final confirmation: the trade deficit will likely worsen, matching the provided answer “worsen.”

Expansionary fiscal policy in an open economy with a floating exchange rate will likely ____ a trade deficit.Single choice

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