Suppose the government of a large open economy implements an expansionary fiscal policy. State and briefly explain the long-run impact on a small open economy's real exchange rate and net exports.
Question
Suppose the government of a large open economy implements an expansionary fiscal policy. State and briefly explain the long-run impact on a small open economy's real exchange rate and net exports.
Solution
Step 1: Understanding Expansionary Fiscal Policy Expansionary fiscal policy refers to the government's increase in spending or decrease in taxes to stimulate economic growth. This policy is often used during a recession or when the economy is not growing at a desired rate.
Step 2: Impact on Large Open Economy In a large open economy, an expansionary fiscal policy will increase the demand for goods and services. This increased demand will lead to higher income and output levels. As income increases, people will demand more goods and services, both domestically produced and imported.
Step 3: Impact on Small Open Economy's Real Exchange Rate The increased demand for imported goods in the large open economy will lead to an appreciation of the small open economy's real exchange rate. This is because the large open economy will need more of the small open economy's currency to purchase its goods, increasing the value of the small open economy's currency relative to the large open economy's currency.
Step 4: Impact on Small Open Economy's Net Exports The appreciation of the small open economy's real exchange rate will make its goods more expensive for the large open economy. This will decrease the small open economy's net exports as its goods become less competitive in the international market.
In conclusion, an expansionary fiscal policy in a large open economy can lead to an appreciation of a small open economy's real exchange rate and a decrease in its net exports in the long run.
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