Consider a small open economy that is operating under a floating-exchange-rate regime with perfect capital mobility. In this economy, an increase in government spending would cause the equilibrium income to:decrease and the exchange rate to increase.increase and the exchange rate to decrease.increase and the exchange rate to remain unchanged.remain unchanged and the exchange rate to increase.
Question
Consider a small open economy that is operating under a floating-exchange-rate regime with perfect capital mobility. In this economy, an increase in government spending would cause the equilibrium income to:decrease and the exchange rate to increase.increase and the exchange rate to decrease.increase and the exchange rate to remain unchanged.remain unchanged and the exchange rate to increase.
Solution
In a small open economy operating under a floating-exchange-rate regime with perfect capital mobility, an increase in government spending would cause the equilibrium income to increase and the exchange rate to decrease.
Here's why:
-
An increase in government spending leads to an increase in aggregate demand. This increase in demand stimulates the economy, leading to an increase in income and output.
-
With perfect capital mobility, the increase in income leads to an increase in interest rates as people have more money to save and invest. This attracts foreign investors who want to take advantage of the higher interest rates.
-
However, to invest in this economy, foreign investors need to buy the local currency, increasing its demand. This leads to an appreciation of the local currency, which means a decrease in the exchange rate (since the exchange rate is the price of foreign currency in terms of the local currency).
So, the final result is an increase in equilibrium income and a decrease in the exchange rate.
Similar Questions
In a small open economy with a fixed exchange rate, if the central bank decreases the money supply, then in the new short-run equilibrium：A.The exchange rate risesB.income risesC.income fallsD.income remain constant
Suppose that in a small open economy with perfect capital mobility and a floating exchange rate, the central bank increases the money supply because the economy is in a recession. This will cause the equilibrium income to _____ and the equilibrium exchange rate to _____.decrease; risedecrease; fallincrease; fallincrease; rise
The central bank of a small open economy with perfect capital mobility and a fixed exchange rate can increase equilibrium income by:devaluing the currency.shifting the LM* curve to the left.allowing the currency to float while retaining a fixed exchange rate.revaluing of the currency.
According to the Mundell-Fleming Model, in a small open economy with perfect capital mobility, when fiscal policy is used to increase government spending under a floating exchange rate regime, what is the likely short-run outcome?A.A. Exchange rate appreciates and net exports decrease.B.B. Exchange rate depreciates and net exports increase.C.C. Exchange rate remains constant and net exports remain unchanged.D.D. Interest rates fall leading to a surge in capital inflows.
____ policy MOST likely will increase the equilibrium level of output in a small open economy with a floating exchange rate.Contractionary monetaryExpansionary fiscalContractionary fiscalExpansionary monetary
Upgrade your grade with Knowee
Get personalized homework help. Review tough concepts in more detail, or go deeper into your topic by exploring other relevant questions.