Explanations about how fiscal policy affects Canada's aggregate demand are incomplete if we do not consider th

Question

Explanations about how fiscal policy affects Canada's aggregate demand are incomplete if we do not consider the crowding-out (or crowding-in) effects, effects of perfect capital mobility, and the effects of net exports. These three effects are crucial for a small open-economy such as Canada.

Suppose the world interest rate is 4%, and Canada's interest rate is initially equal to 4%. Canada has a flexible exchange rate.

8.4. True or False: A fixed exchange rate in a small open economy magnifies the impact of fiscal policy on aggregate demand.

True

False

Answer 1

False

In a fixed exchange rate economy, an expansionary fiscal policy will increase demand for domestic goods as well as imports. If there are import restrictions, excess demand conditions may develop inflationary price spiral, putting further pressure on the exhnage rate to change and may force a devalation.