Assume that there is a simultaneous increase in government spending and a monetary contraction. In a flexible exchange rate regime, we know with certainty that such a policy mix will cause which of the following?
A) A decrease in net exports.
B) An increase in the domestic interest rate.
C) An increase in the exchange rate.
D) Both A and B.
E) Both B and C.

Question

Quizplus · Accepted Answer

With a simultaneous increase in government spending and a monetary contraction, the increase in government spending will lead to an increase in imports, reducing net exports and causing a decrease in net exports. At the same time, the monetary contraction will increase the domestic interest rate, making it more attractive for international investors to invest in the domestic market, which will cause capital inflows and appreciation of the exchange rate. Therefore, the correct choice is D, which represents both a decrease in net exports and an increase in the domestic interest rate.

Assume That There Is a Simultaneous Increase in Government Spending