In a large but open economy, when a fiscal expansion takes place, the interest rate goes up and some investment is crowded out; the expansion also causes a trade:
A) surplus and a fall in the real exchange rate.
B) deficit and a rise in the real exchange rate.
C) surplus and a rise in the real exchange rate.
D) deficit and a fall in the real exchange rate.

Question

Quizplus · Accepted Answer

When a fiscal expansion takes place in a large but open economy, it increases the demand for goods and services, which in turn increases the demand for imports. This leads to a trade deficit. As a result of the increased demand for credit to finance the fiscal expansion, interest rates tend to rise, which leads to a rise in the real exchange rate. Therefore, Choice B is correct.

In a Large but Open Economy, When a Fiscal Expansion