Question

Consider the short-run impact of the U.S. fiscal policy action on Bermuda, a small open economy that maintains a fixed exchange rate with the U.S. dollar. What is the impact of the U.S. fiscal policy action on consumption, investment, and the unemployment rate in Bermuda? Explain.

Answer 1

Expansionary fiscal policy leads to increase in the government spending and reduces tax in the economy, if U.S. uses expansionary fiscal policy which leads to rightward shift in the IS curve which increases the interest rate in the U.S. High interest rate attracts the foreign investors which leads to capital inflow into the country and increases the demand for dollar which increases the value of U.S. dollar in the foreign exchange market (appreciation of the dollar means the exchange rate between Bermuda currency and dollar increases, it means that now 1 U.S. dollar can buy more Bermuda currency), as the Bermuda government maintains the fixed exchange rate, the government reduces the supply of Bermuda currency and increase the supply of dollar in the Bermuda, decrease in the supply of Bermuda currency shifts the LM curve to the left which increases the interest rate in the Bermuda, increase in the interest rate reduces the investment which reduces the real income, reduction in the real income reduces the consumption in the Bermuda which reduces the aggregate demand further and real income in the Bermuda decreases further which increases the unemployment in the economy.