Canada is a small open economy with a flexible exchange rate. Which effect will a contractionary fiscal policy have?
A) It will cause the Canadian interest rate to fall below the world interest rate for a short period of time, which in turn will cause the dollar to depreciate and net exports to increase.
B) It will cause the Canadian interest rate to rise above the world interest rate for a short period of time, which in turn will cause the dollar to appreciate and net exports to decrease.
C) It will cause the Canadian interest rate to fall below the world interest rate for a short period of time, which in turn will cause the dollar to appreciate and net exports to decrease.
D) It will cause the Canadian interest rate to rise above the world interest rate for a short period of time, which in turn will cause the dollar to depreciate and net exports to increase.

Question

Quizplus · Accepted Answer

A contractionary fiscal policy will reduce aggregate demand, which will lead to a fall in the Canadian interest rate below the world interest rate. This will cause the dollar to depreciate, making Canadian exports cheaper and imports more expensive, leading to an increase in net exports.

Canada Is a Small Open Economy with a Flexible Exchange