A fiscal expansion in the small open economy, under the usual
Keynesian conditions, will lead in the long-run to a rise in the
country's real exchange rate, while a policy-induced devaluation
of the nominal exchange rate, either by lowering the value at which
the exchange rate is fixed or by expanding the money supply, will
have no long-run effect on the real exchange rate.
True or False?
The statement is true. The fiscal expansion will shift the IS
curve to the right. If the exchange rate is flexible, the
domestic currency will appreciate and the real exchange rate will
rise to drive IS back to its old position. If the exchange rate
is fixed, output and employment will expand in the short run but
the price level and real exchange rate will rise in the long-run
to shift IS back to the intersection of ZZ and the vertical full-employment
line. A devaluation will also shift the IS curve to the right and
the money supply will expand automatically, shifting LM to the right
by the same amount. But in the long-run, the price level will rise,
increasing the real exchange rate sufficiently to drive IS back to
its intersection with ZZ and the full-employment line. This will
return the real exchange rate to its original level.
When the fixed nominal exchange rate is adjusted to a lower
level, the rise in the price level must have exactly the opposite effect
on IS as the devaluation of the nominal exchange rate had---prices and
the nominal exchange rate must thus move in the same proportion so that
the real exchange rate is unaffected. An alternative way for the authorities
to devalue the currency would be to let the exchange rate float and
increase the money supply. It has already been shown above that this will
have no effect on income and the real exchange rate in the long
run. The price level will rise and the nominal exchange rate
will devalue, both in the same proportion as the nominal money stock
increases.
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