In a model with perfect capital mobility and flexible exchange rates, an increase in government purchases will

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In a model with perfect capital mobility and flexible exchange rates, an increase in government purchases will lead to an increase in the demand for domestic goods and services, which in turn will increase domestic output and prices. The increase in prices will lead to an appreciation of the exchange rate, making domestic goods more expensive relative to foreign goods and therefore reducing net exports. This is known as the crowding-out effect. Private domestic investment is also likely to decrease as interest rates rise in response to the increase in government spending. Therefore, choice C, which reflects a crowding-out effect of the increase in government purchases on net exports, is the best choice.

In a Model with Perfect Capital Mobility and Flexible Exchange