Question

Which of the following is/are CORRECT in the case of a small open economy with floating exchange rate?

• A. Fiscal expansion raises income.
• B. Fiscal expansion leaves income at the same level.
• C. Capital inflow leads to fall in net exports.
• D. Capital inflow leads to increase in net exports.

Hint:

In a small open economy with floating exchange rates, fiscal expansion can have a limited or neutral effect on income in the long term, and capital inflows typically lead to a decrease in net exports due to currency appreciation.

Answer 1

The Correct Option is B, D

Step 1: Understand the impact of fiscal policy and capital inflows in a small open economy.
In a small open economy with floating exchange rates, fiscal expansion and capital flows have significant effects on income, exchange rates, and net exports.
Step 2: Analyze the options.
- Option (A) is incorrect. In a small open economy with a floating exchange rate, fiscal expansion does not always raise income in the long run. It may raise domestic income in the short run, but it can lead to higher interest rates and currency appreciation, which could offset the expansionary effect.
- Option (B) is correct. Fiscal expansion can have no long-term effect on income due to crowding out and the appreciation of the exchange rate.
- Option (C) is correct. Capital inflows lead to an appreciation of the domestic currency, which makes exports more expensive and thus reduces net exports.
- Option (D) is incorrect. Capital inflows typically appreciate the currency, making exports more expensive and leading to a decrease in net exports.
Final Answer: \[ \boxed{\text{(B) and (C) are correct in the case of a small open economy with floating exchange rate.}} \]