In a small open economy with a floating exchange rate, if the government adopts an expansionary fiscal policy, in the new short-run equilibrium:
A) income and the exchange rate will both rise.
B) the exchange rate will rise, but income will remain unchanged.
C) income will rise, but the exchange rate will remain unchanged.
D) both income and the interest rate will rise.

Question

Quizplus · Accepted Answer

An expansionary fiscal policy will increase government spending and/or reduce taxes, leading to an increase in aggregate demand. In a small open economy with a floating exchange rate, the increase in demand will lead to an appreciation of the currency. This appreciation of the exchange rate will make exports more expensive and imports cheaper, reducing net exports and partially offsetting the expansionary fiscal policy. Therefore, while the exchange rate will rise, income will remain unchanged. Note that this is in the short run, and in the long run, the exchange rate may return to its original level, and income may increase.

In a Small Open Economy with a Floating Exchange Rate