Question

With a flexible exchange rate and free capital mobility, an expansionary fiscal policy is:

A) Ineffective because a higher domestic interest rate will crowd out investment

B) Very effective because domestic interest rate will not rise and hence crowding out of investment cannot occur

C) Ineffective because the exchange rate will appreciate, crowding out net exports

D) Very effective because both domestic demand and net exports will rise

E) Both B. and D.

Answer 1

Answer:C

EXPLAINATION : In case of complete capital mobolity crowding out is complete. Hence in case of complete mobility combined with floating exchange rates and Expansionary fiscal policy it'll lead to increase in interest rates hence increased interest rates generate sufficient capital inflows to cause the exchange rate to appreciate.There will be crowding out effect, due to the decline in international competitiveness which means exports will decrease or crowding out of net exports.

Hope it helps.