Suppose there is a fiscal expansion in the current period. This fiscal expansion will tend to cause a smaller increase in current output when:
A) an increase in the current interest rate causes expectations of expansionary monetary policy in the future.
B) an increase in the current interest rate causes an increase in expected future interest rates.
C) an increase in current output causes an increase in expected future output.
D) Both A and B.
E) Both B and C.

Question

Quizplus · Accepted Answer

When an increase in the current interest rate causes an increase in expected future interest rates, it will discourage current investment and consumption, which will limit the increase in current output resulting from the fiscal expansion. Therefore, the increase in current output will be smaller. Option A is incorrect because expansionary monetary policy in the future would have the opposite effect: it would encourage current investment and consumption, leading to a larger increase in current output. Option C is also incorrect because an increase in current output would not affect expected future output, unless it signals a permanent increase in productivity or an increase in the growth rate of potential output.

Suppose There Is a Fiscal Expansion in the Current Period