Explain how expansionary fiscal policy impacts a small open economy with a floating exchange rate; and...

Explain how expansionary fiscal policy impacts a small open economy with a floating exchange rate; and compare that to how expansionary fiscal policy works for a country with a fixed exchange rate

Solutions

Expert Solution

Expansionary fiscal policy in a small open economy ( with floating exchange rate )

In case of a small open economy, with floating exchange rate, an expansionary fiscal policy ( increase in government spending or decrease in taxes )

Increases the planned expenditure in the economy
That's why the IS curve shifts to the right ( IS₀ to IS₁ ) as shown in the figure below
This raises the exchange rate ( e₀ to e₁ ) ( currency appreciates )
But, as the domestic currency appreciates, the domestic goods become more expensive than foreign goods, hence the net exports (NX) of the country falls
Therefore, the fall in net exports actually offsets the increase in income arising from the expansionary fiscal policy and has no effect on the aggregate income and output ( Y₀ )

Expansionary fiscal policy in a small open economy ( with fixed exchange rate )

In case of a small open economy, with fixed exchange rate, an expansionary fiscal policy ( increase in government spending or decrease in taxes )

Increases the planned expenditure in the economy
That's why the IS curve shifts to the right ( IS₀ to IS₁ ) as shown in the figure below
Therefore, it much like the floating exchange rate tries to put upward pressure on the exchange rate
But, here as the Central Banks stand ready to maintain the fixed exchange rate, they respond by increasing the money supply
That's why the LM curve shifts to the right ( LM to LM₀ ) as shown in the figure below
The exchange rate here remains the same ( e₀ )
But it raises the aggregate income and output in the economy( Y₀ to Y₁ )

Summary

Therefore we can conclude by saying that the impacts of expansionary fiscal policy in a small open economy are very different under

Floating exchange rate and
Fixed exchange rate

Under floating exchange rate,

Currency appreciates ( increase in the exchange rate ), but the aggregate income and output stays the same

But, under a fixed exchange rate,

Aggregate income and output rises, but the Central Bank is willing and able to maintain a fixed exchange rate

Rahul Sunny answered 3 months ago

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