Under a fixed exchange rate system, a contractionary fiscal policy causes the central bank to intervene in the foreign exchange market and sell foreign exchange.

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Under a fixed exchange rate system, the central bank is committed to maintaining a fixed exchange rate. A contractionary fiscal policy will lead to a decrease in aggregate demand, which will put downward pressure on the exchange rate. To prevent the exchange rate from falling below the fixed rate, the central bank will intervene in the foreign exchange market and sell foreign exchange.

Under a Fixed Exchange Rate System, a Contractionary Fiscal Policy