With floating exchange rates, expansionary fiscal policy is more effective in increasing output when the:
A)FE curve is flatter than the LM curve.
B)FE curve is steeper than the LM curve.
C)FE curve is horizontal and the LM curve is vertical.
D)FE curve coincides with the LM curve.

Question

Quizplus · Accepted Answer

When the FE curve is steeper than the LM curve, an increase in government spending or reduction in taxes will lead to a greater increase in output and a smaller increase in the interest rate. This is because the steeper FE curve implies a larger shift in aggregate demand for a given increase in government spending or reduction in taxes. This is particularly true when exchange rates are floating because changes in the exchange rate can also help to offset any potential crowding out effects that may result from an increase in interest rates. Therefore, the steeper the FE curve, the more effective expansionary fiscal policy will be in increasing output.

With Floating Exchange Rates, Expansionary Fiscal Policy Is More Effective