Question

a) Consider a small open classical economy. Use an appropriate model and graph to 

explain in detail what happens to the real exchange rate if the Government: 

i. Engaged in expansionary fiscal policy 

ii. Engaged in contractionary fiscal policy

Answer 1

i) When the government adopts an expansionary fiscal policy, interest rates rise because the government must sell bonds to generate the funds it needs to spend; as a result, foreign capital and demand for dollars rise, and the exchange rate rises. 

ii) In a fixed exchange rate system, contractionary fiscal policy will result in a drop in GNP and no change in the exchange rate in the short run. The current account balance will grow due to contractionary fiscal policy, which includes a reduction in G.