If Canada's Parliament decreases government spending by $25 billion, then we expect the world interest rate t

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.

8.1. If Canada's Parliament decreases government spending by $25 billion, then we expect the world interest rate to ____.

A. Remain unchanged

B. Decrease

C. Increase

Answer 1

B. Decrease - but for very small value - since Canadian economy is only 2.6% of world output and gov share in Canadian economy is relativelly small - fall in gov spending will lead to fall in demand for financing.