Question

The government in an open economy cuts spending to reduce the budget deficit. As a result, the interest rate ________, leading to a capital ________ and a real exchange rate ________.
a. falls, outflow, appreciation
b. falls, outflow, depreciation
c. falls, inflow, appreciation
d. rises, inflow, appreciation

Answer 1

When government cuts its spending for reducing budget deficit, then aggregate demand decrease because government spending is part of aggregate demand. So price level increase in the economy, so real money supply decrease in the economy. As a result, money supply curve shifts leftward. As a result, interest rate increase. So it will attract foreign capital in the domestic country. So demand for domestic country currency increase. So it leads to domestic currency appreciation. So the real exchange rate appreciation.

Hence it can be said that the government in the open economy cuts spending to reduce the budget deficit. As a result, the interest rate rises, leading to a capital inflow and a real exchange rate appreciation.

Hence option d is the correct answer.

When the government cuts its spending for reducing the budget deficit, then aggregate demand decrease because government spending is part of aggregate demand. Hence the D curve shifts leftward. So price level decrease in the economy, so real money supply increase in the economy. As a result, money supply curve shifts rightward. As a result, interest rate decreases. So it will attract less foreign capital and more domestic currency in the domestic country. So demand for domestic country currency decrease. So it leads to domestic currency depreciation. So the real exchange rate appreciation.

Hence it can be said that the government in the open economy cuts spending to reduce the budget deficit. As a result, the interest rate falls, leading to capital outflow and a real exchange rate appreciation.

Hence option a is the correct answer.