Question

1. Suppose the assumptions of a Keynesian model apply and that a country has a flexible exchange rate regime.   There are no restrictions on private capital moving into or out of the country. Which of the following is true if the domestic government decides to undertake a large infrastructure program as a stimulus program to increase GDP?

1. The infrastructure program will tend to raise domestic interest rates, which then leads to a private capital account surplus as foreign investors increase their purchase of domestic bonds with higher interest rates. This inflow of foreign capital will tend to decrease domestic interest rates and spur even more domestic economic activity.

2. The money supply will increase as the government begins to spend more. This will decrease the interest rate, which will increase the amount of borrowing for housing and expansion of plants, which will spur even more domestic economic activity.

3. The infrastructure program will tend to raise domestic interest rates, which then leads to pressure for the domestic currency to depreciate. The falling value of the domestic currency will make domestic goods cheaper abroad, which will tend to increase aggregate demand and expand the economy.

4. None of the above is true.

    

e.    Only a. and c. are true.

Answer 1

"D"

None of the above are correct. An increase in the government expenditure will increase the interest rate and that will increase the inflow of foreign capital, it will lead to an appreciation of the local currency and decrease in the exports and increase in the import. this will take the economy back to the level where it started i.e. pre government expenditure level. the answer is "D".