Question

Assume the small open economy starts from a position of a balanced trade. Giving reasons, clearly explain what the effect of an expansionary fiscal policy abroad (by a large open economy) will be on the trade balance of a small open economy? You may need to draw diagrams to determine the effect. However, do not provide diagrams with the answer. (100 words maximum)

Answer 1

Effect of Expansionary fiscal policy abroad on trade balance of of small economy will be -

• Due to expansion of fiscal policy abroad there will de trade deficit in small open economy
• There will also be appreciation in the real exchange rate in small open economy
• Since due to change fiscal policy there will be change saving Investment curve as it shifts leftward , vertically.
• This will lead to fall in the Domestic currency which Invested abroad.
• And the fall in supply in domestic currency will lead to rise in real exchange rate from equlibrium