Suppose country A is a small open economy with free capital flows and a fixed exchange rate system, which of the statement is ture?A.With expansionary fiscal policy, country A's income increases.B.With expansionary fiscal policy, country A's income decreases.C.With expansionary fiscal policy, country A's exchange rate increases.D.With expansionary fiscal policy, country A's exchange rate decreases.
Question
Suppose country A is a small open economy with free capital flows and a fixed exchange rate system, which of the statement is ture?A.With expansionary fiscal policy, country A's income increases.B.With expansionary fiscal policy, country A's income decreases.C.With expansionary fiscal policy, country A's exchange rate increases.D.With expansionary fiscal policy, country A's exchange rate decreases.
Solution
The correct statement is A. With expansionary fiscal policy, country A's income increases.
Here's why:
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Expansionary fiscal policy involves government measures to increase economic activity, such as increasing government spending or decreasing taxes.
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In a small open economy with free capital flows, such measures would increase the demand for goods and services.
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This increased demand would stimulate businesses to produce more, leading to an increase in income and employment.
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However, because the country has a fixed exchange rate system, the exchange rate would not change in response to the fiscal policy. The central bank would intervene in the foreign exchange market to keep the exchange rate fixed.
So, the expansionary fiscal policy would increase the country's income, but it would not change the exchange rate. Therefore, statement A is true, and statements B, C, and D are false.
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