Assume the AA – DD equilibrium model under the floating exchange rate regime. How will the fiscal policy impact the equilibrium? Select one – the most appropriate answer.

Question

BlackTom AI · Accepted Answer

Question restatement: We are looking at the AA–DD equilibrium model under a floating exchange rate regime and must identify how fiscal policy affects the new equilibrium.

Option A: "Fiscal expansion brings about jump in aggregate demand and consequently increase in output that in turn leads to diminishing interest rate and domestic currency depreciation. New equilibrium is set."
- Why this is incorrect: Fiscal expansion (increase in government spending or tax cuts) under floating rates typically shifts the IS curve right, raising output and generally pushing interest rates up (not down). Higher interest rates tend to attract capital, causing currency appreciation rather than depreciation. Therefore, the claim of a diminishing interest rate and a depreciation is inconsistent with standard open-economy macro results under floating rates.

Option B: "Fiscal expansion brings about fall in aggregate demand and consequently increase in output that in turn leads to diminishing interest rate and domestic currency depreciation. Equilibrium is restored."
- Why this is incorrect: This option flips the direction of the effects. Expansion should raise aggregate demand, not fall. It also predicts an increase in output but then a diminishing interest rate and depreciation, which conflicts with the typical outcome where expansion tends to raise rates and appreciate the currency. The combination of a fall in demand and an increase in output is internally inconsistent.

Option C: "Fiscal restriction brings about cut in aggregate demand and consequently decrease in output that in turn leads to increasing interest rate and domestic currency appreciation. New equilibrium is set."
- Why this is incorrect: Contractionary fiscal policy reduces output, but it would be expected to lower, not raise, the domestic interest rate in a floating-rate small open economy (as money demand shifts and monetary policy may respond to stabilize). Moreover, an increase in interest rate would typically cause currency appreciation, not appreciation plus the stated sequence of events here is inconsistent with the standard transmission mechanism in the AA–DD framework under floating rates.

Option D: "No correct answer."
- Why this is incorrect: There is a logically consistent option among the given choices that matches the conventional chain for contractionary fiscal policy in the AA–DD model with floating rates: output falls, interest rate falls, and the domestic currency depreciates. Therefore saying there is no correct answer overlooks the coherent sequence described in the model.

Option E: "Fiscal restriction brings about cut in aggregate demand and consequently decrease in output that in turn leads to diminishing interest rate and domestic currency depreciation. New equilibrium is set."
- Why this is correct: This option aligns with the typical transmission in an AA–DD framework under floating exchange rates. A fiscal restriction shifts the IS curve left, reducing aggregate demand and output. With the space for monetary policy to accommodate, interest rates tend to fall, and the capital outflow tendency or reduced return on domestic assets can lead to a depreciation of the domestic currency. The description ends with a new equilibrium being established, which is the standard conclusion in these comparative-static exercises.

Summary of reasoning across options: Each choice was weighed against the canonical effects in a small open economy under a floating exchange rate: how fiscal policy shifts affect demand, output, interest rates, and the exchange rate. The only option that consistently matches the conventional sequence for a fiscal restraint is the one describing a fall in output accompanied by falling interest rates and a depreciating currency, ending with a new equilibrium.

Assume the AA – DD equilibrium model under the floating exchange rate regime. How will the fiscal policy impact the equilibrium? Select one – the most appropriate answer.单项选择题

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