Under floating exchange rates, fiscal expansion induces a boom and higher interest rates causing an exchange rate appreciation that crowds out some net exports, reinforcing domestic crowding out of consumption and investment.

Question

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Under floating exchange rates, a fiscal expansion typically leads to higher interest rates as the government competes for available funds, attracting foreign capital and appreciating the domestic currency. This appreciation makes exports more expensive and imports cheaper, potentially reducing net exports. The higher interest rates can also crowd out private investment and consumption, as borrowing costs increase.

Under Floating Exchange Rates, Fiscal Expansion Induces a Boom and Higher