Fiscal Policy under Flexible Exchange Rates Quiz

Under flexible exchange rates with perfect capital mobility, expansionary fiscal policy is completely ineffective in the Mundell Fleming model. When the government increases spending, the IS curve shifts right and pushes the domestic interest rate above the world rate. This attracts capital inflows, causing the currency to appreciate. The appreciation reduces net exports by exactly the same amount as the initial spending increase, leaving total output unchanged. The fiscal stimulus is fully offset by a deteriorating trade balance.

The answer is True. When the government expands spending under flexible exchange rates, the IS curve shifts right and puts upward pressure on the domestic interest rate. This attracts capital inflows from abroad because the domestic rate is temporarily above the world rate. The resulting increase in demand for domestic currency causes it to appreciate. The appreciation then reduces exports and increases imports, crowding out net exports and offsetting the initial stimulus to output.

In the Mundell Fleming model under flexible exchange rates, crowding out occurs through the exchange rate rather than the interest rate. Expansionary fiscal policy temporarily raises the domestic interest rate above the world rate, attracting capital inflows. These inflows appreciate the currency, making exports more expensive and imports cheaper. The resulting fall in net exports offsets the initial rise in demand from government spending, leaving output unchanged. This exchange rate crowding out is the key mechanism.

When expansionary fiscal policy is used under flexible exchange rates, the resulting currency appreciation makes domestic goods more expensive for foreign buyers, reducing exports. At the same time, cheaper imports increase domestic demand for foreign goods. The combination of falling exports and rising imports worsens the current account. This deterioration in net exports exactly offsets the fiscal stimulus, explaining why fiscal policy is ineffective at raising output under this regime.

When government spending rises under flexible exchange rates, the IS curve shifts right, the domestic interest rate briefly exceeds the world rate, and capital flows in, appreciating the exchange rate. This appreciation crowds out net exports, ultimately leaving output unchanged. The claim that the currency depreciates is incorrect; under this scenario the currency appreciates due to capital inflows, which is the very mechanism that neutralizes the fiscal expansion in the open economy.

The answer is False. Even when the economy starts below full employment, fiscal policy cannot permanently raise output under flexible exchange rates and perfect capital mobility in the Mundell Fleming model. The exchange rate appreciation that follows the fiscal expansion fully crowds out net exports, returning output to its original level. The model shows that the policy mix matters: monetary policy, not fiscal policy, is the effective tool for raising output under flexible exchange rates.

In the Mundell Fleming model under flexible exchange rates, the exchange rate serves as the primary adjustment mechanism for fiscal policy. When government spending rises, upward pressure on the interest rate attracts capital inflows that appreciate the currency. This appreciation shifts demand away from domestic goods toward imports and away from exports, directly neutralizing the positive demand effect of the fiscal expansion. The exchange rate effectively absorbs the fiscal shock and prevents it from raising output.

A contractionary fiscal policy under flexible exchange rates follows the same logic in reverse. Lower government spending reduces the domestic interest rate below the world rate, triggering capital outflows. These outflows depreciate the exchange rate, which makes domestic exports cheaper and imports more expensive. The resulting improvement in net exports offsets the contractionary impact of the spending cut, leaving output unchanged. The exchange rate depreciation neutralizes the fiscal contraction just as appreciation neutralizes fiscal expansion.

The answer is True. A central and well-known result of the Mundell Fleming model is that fiscal policy is ineffective under flexible exchange rates with perfect capital mobility. The exchange rate appreciation triggered by the fiscal expansion exactly offsets the stimulus through a reduction in net exports. This result has important implications for policymakers in open economies because it suggests that fiscal expansion should not be relied upon to raise output when the exchange rate floats freely.

Fiscal expansion under flexible exchange rates causes currency appreciation from capital inflows, a worsening current account as appreciation reduces exports and raises imports, and a compositional shift in demand from net exports to government spending. However, total output does not rise because the current account deterioration exactly offsets the fiscal stimulus. The claim that output rises permanently is inconsistent with the Mundell Fleming result under this exchange rate regime.

In a closed economy, fiscal expansion raises output because there is no exchange rate appreciation or capital mobility to create an offsetting reduction in net exports. The fiscal multiplier operates fully. In a small open economy with flexible exchange rates and perfect capital mobility, the exchange rate appreciation that follows fiscal expansion precisely eliminates the stimulus effect. The external sector in the open economy creates the crowding out mechanism that simply does not exist in a closed economy.

The answer is False. Under flexible exchange rates in the Mundell Fleming model, fiscal expansion causes the current account to worsen rather than improve. The currency appreciation that follows the fiscal stimulus reduces exports and increases imports, deteriorating the current account. This worsening of the trade balance is the mechanism through which the fiscal expansion is crowded out, leaving total output unchanged while shifting the composition of demand away from net exports and toward government spending.

The Mundell Fleming model identifies monetary policy as the effective tool for raising output under flexible exchange rates. An expansionary monetary policy increases the money supply, lowers the domestic interest rate, triggers capital outflows, and depreciates the currency. The depreciation makes exports cheaper and imports more expensive, increasing net exports and raising output. Unlike fiscal policy, monetary expansion is not crowded out through exchange rate appreciation; instead, depreciation amplifies its impact on demand.

In the Mundell Fleming model, fiscal policy is effective under fixed exchange rates because the central bank expands the money supply to maintain the peg, preventing the interest rate from rising and avoiding the crowding out effect. Under flexible exchange rates, fiscal policy is ineffective because the interest rate rise attracts capital, appreciates the currency, and reduces net exports. The claim that fiscal policy produces identical results under both regimes is incorrect.

Full crowding out under flexible exchange rates means that every dollar of additional government spending is exactly offset by a reduction in net exports caused by exchange rate appreciation. The IS curve shifts right, but this triggers capital inflows that appreciate the currency, shifting the IS curve back to its original position through the fall in net exports. The net result is that output does not change; the fiscal expansion only alters the composition of demand without affecting the overall level.