In a small open economy with a floating exchange rate, a rise in government spending in the new short-run equilibrium:
A) chokes off investment, but not by as much as the new government spending.
B) chokes off an amount of investment just equal to the new government spending.
C) attracts foreign capital, thus raising the exchange rate and reducing net exports, but not by as much as the new government spending.
D) attracts foreign capital, thus raising the exchange rate and reducing net exports by an amount just equal to the new government spending.

Question

Quizplus · Accepted Answer

In a small open economy with a floating exchange rate, a rise in government spending will lead to an appreciation of the exchange rate, which will reduce net exports. The amount of the reduction in net exports will be equal to the increase in government spending, as the exchange rate will adjust to keep the current account in balance.

In a Small Open Economy with a Floating Exchange Rate