In an open economy with fixed exchange rates, contractionary fiscal policy causes:
A) interest rates to rise and an inflow of foreign capital causing the government to intervene and buy foreign currency.
B) interest rates to fall and an outflow of foreign capital causing the government to intervene and sell foreign currency.
C) interest rates to rise and an outflow of foreign capital causing the government to intervene and sell foreign currency.
D) interest rates to fall and an outflow of foreign capital causing the government to intervene and buy foreign currency.
E) interest rates do not change and an inflow of foreign capital causes the government to intervene and buy foreign currency.

Question

Quizplus · Accepted Answer

Contractionary fiscal policy typically involves reducing government spending or increasing taxes, which leads to a decrease in aggregate demand. This can cause interest rates to fall as there is less demand for funds. Lower interest rates make domestic investments less attractive, potentially leading to an outflow of foreign capital as investors seek higher returns elsewhere. In a fixed exchange rate system, to prevent the domestic currency from depreciating due to these capital outflows, the government might intervene by selling foreign currency from its reserves to buy domestic currency, thereby supporting its value.

In an Open Economy with Fixed Exchange Rates, Contractionary Fiscal