Question

1. Explain how and why fiscal policy can have different effects on the output level depending on whether it is implemented in a fixed or floating exchange rate regimes.

Answer 1

Under Floating exchange rate regime,

A fiscal expansion will lead to increase in aggregate demand causing increase in output ans price level. Also, increase in aggregate demand will increase money demand increase interest rate at given level of money supply. This will increase net capital inflow causing interest rate to appreciate.

Under fixed rate regime,

Due to appreciation of exchange rate, central bank increases money supply so that exchange rate devalues to its fixed value. This increase in money supply increases output and price level further.

Thus, under fixed exchange rate regime, output increases more dur to use of fiscal expansion than in floating exchamge rate regime. Similarly, fiscal contraction will have a more profound affect on output in fixed exchange rate regime.

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