Compared to a closed economy, expansionary fiscal policy in an open economy has a smaller effect on aggregate demand because:
A)it may increase interest rates and reduce domestic investment spending.
B)the government may borrow abroad and decrease foreign capital inflows.
C)it may increase interest rates and reduce net exports.
D)it may increase government spending on imports.

Question

Quizplus · Accepted Answer

In an open economy, an expansionary fiscal policy may lead to an increase in interest rates, which in turn reduces net exports as it leads to a stronger domestic currency relative to foreign currencies. This is because higher interest rates attract foreign investment, which strengthens the exchange rate, making exports more expensive and imports cheaper. Therefore, choice C states that expansionary fiscal policy may increase interest rates and reduce net exports, which is the correct explanation. Choices A, B, and D are incorrect as they do not directly relate to the effect of expansionary fiscal policy on aggregate demand.

Compared to a Closed Economy, Expansionary Fiscal Policy in an Open