Question

Explain how expansionary fiscal policy impacts output, the real interest rate, exchange rate, and net exports. Assume flexible exchange rate system. (Please be specific with explanation)

Answer 1

So, the effect of the expansionary fiscal policy (rightward shift of the IS curve) would lead to increased interest rates and higher output level, reduced unemployment and increased price levels.

The effect on the real interest rate, however, can be both ways, as both inflation and nominal interest rate rises, and net effect on real interest rate will depend on which of the two rises more!

Now, with S curve shifted outwards, we have a BOP surplus, and the flexible exchange rate leads to appreciation of the domestic currency. This will decrease exports and encourage imports.

Also, note that the drop in exports and rise in imports will drive this situation back to the older equilibrium.

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