In addition this capital inflow also affects the

This preview shows page 4 - 5 out of 5 pages.

In addition, this capital inflow also affects the value of domestic currency. Because foreign investors need to buy domestic currency to invest in the domestic economy, the capital inflow increases the demand for domestic currency. This results in the appreciation of domestic currency, making domestic goods more expensive relative to foreign goods, consequently reducing net Page 4
exports. But this fall in net exports is offset by the effects of the expansionary policy on income, which leaves income and output at the same level.In short, in a small open economy with perfect capital mobility, fiscal policy crowds out net exports by causing the exchange rate to appreciateAn appropriate monetary policy adjustment that would allow the economy to move to a higher exchange rate is through cutting the money supply. Monetary policy affects output by affecting the components of aggregate demand. In a small open economy, a decrease in the money supply causes the exchange rate to rise. A rise in the exchange rate means domestic goods are more expensive relative to foreign goods. Domestic residents will want to buy more imported goods and foreigners will want to buy less of our domestic goods, which subsequently cause a decrease in the net export, similar to an increase in government spending or tax cut. However, in contrary to the expansionary fiscal policy, the fall in net exports is not offset by the effects of the cut in the monetary policy, which results in lower income and domestic output. The decrease in domestic output is also a result of a fall in net exports, an economy that exports less will produce less. Page 5

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture