In a large but open economy, when a fiscal expansion takes place, the interest rate goes up and some investment is crowded out, and the expansion also causes a trade:
A)surplus and a fall in the real exchange rate.
B)deficit and a rise in the real exchange rate.
C)surplus and a rise in the real exchange rate.
D)deficit and a fall in the real exchange rate.

Question

Quizplus · Accepted Answer

In a large but open economy, when there is a fiscal expansion, the increase in demand for loanable funds leads to an increase in the interest rate. This increase in the interest rate reduces investment and causes some crowding out. Additionally, as a result of the fiscal expansion, there is an increase in income and an increase in demand. This leads to an increase in imports which increases the trade deficit. The increase in demand for domestic currency to purchase foreign currency to pay for the imports raises the value of the domestic currency, causing a rise in the real exchange rate. Therefore, the correct choice is B) deficit and a rise in the real exchange rate.

In a Large but Open Economy, When a Fiscal Expansion