Question

Under a flexible exchange rate regime, the government decides to conduct expansionary fiscal policy by increasing...

Under a flexible exchange rate regime, the government decides to conduct expansionary fiscal policy by increasing government spending

a. What happens to equilibrium output, the interest rate, and the exchange rate? Explain and show using the appropriate graphs.

b. What happens to the components of aggregate demand: consumption, investment, government spending and exports?

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Answer #1

a) Under expansionary fiscal policy, there is an increase in Government spending. This causes the Aggregate demand in the goods market to shift to the right. With multiplier effect, consumption rises. This should raise the rate of interest in the economy and so private investment may fall.

Overall, this causes the equilibrium output to increase. This increase in output and interest rate is shown by a rightward shift of the IS curve in the IS-LM model. With increased rate of interest, there is a decline in net capital outflow and an increase in demand for domestic currency. Hence, exchange rate increases while net exports fall, resulting in increasing the trade deficit (or reducing trade surplus).

b) Consumption should increase due to multiplier effect as disposable income increases. Investment may fall since rate of interest is increased. Government spending has increased. Net exports have reduced

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