Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level of output. Suppose that government spending decreases. Given this information, we know that this fiscal contraction will cause:
A) the real exchange rate to be unchanged in the medium run.
B) the real exchange rate only decreases in the medium run if foreign prices rise.
C) the real exchange rate to be permanently higher in the medium run.
D) the effects of this fiscal contraction on the real exchange rate will be ambiguous in the medium run.
E) the real exchange rate to be permanently lower in the medium run.

Question

Quizplus · Accepted Answer

Under a fixed exchange rate regime, a decrease in government spending (fiscal contraction) would initially lead to a decrease in domestic demand, which could reduce inflationary pressures and potentially lower domestic prices relative to foreign prices. This change can make domestic goods cheaper relative to foreign goods, effectively lowering the real exchange rate in the medium run. The real exchange rate is the price of domestic goods in terms of foreign goods, and a decrease indicates that domestic goods have become cheaper or more competitive compared to foreign goods. This adjustment helps the economy reach a new equilibrium at a lower real exchange rate, assuming other factors remain constant.

Assume That Policy Makers Are Pursuing a Fixed Exchange Rate