Answer to Question #250357 in Microeconomics for Josef Albertina

Question

Explain why a cut in government spending has a larger effect under a fixed exchange rate system and perfect capital mobility than in a closed economy model?

Answer 1

Under a fixed exchange rate system,a decrease in government spending is called contractionary fiscal policy. This has a large effect because it is associated with a significant decrease in budget deficit or increase in government budget surplus.

Under a perfect capital mobility system, Capital moves without cost across different economies. A cut in government spending will slow down the movement of capital and this makes it more risky to invest or lend money to other economies. This greatly affects the level of investment in foreign countries and also at domestic level.

However, in a closed economy model, domestic consumers are provided with everything they need within the borders of their country. A cut in government spending here signifies high level of savings and low interest rates, and results in increase in investments only within the economy, thus, the effect is not significantly great.