In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the new short-run equilibrium:
A) the exchange rate rises but income does not rise.
B) income rises but the exchange rate does not rise.
C) both income and the exchange rate rise.
D) neither income nor the exchange rate rises, as the money supply contracts.

Question

Quizplus · Accepted Answer

An increase in government purchases will increase aggregate demand in the short run, leading to an increase in output/income. However, since the economy has a fixed exchange rate, there will be an increase in demand for the currency, which will lead to an appreciation of the currency. This appreciation of the currency will make exports more expensive and imports cheaper, which will lead to a decrease in net exports and partially offset the initial increase in aggregate demand. Therefore, income will rise but the exchange rate does not rise.

In a Small Open Economy with a Fixed Exchange Rate