In a small open economy with fixed exchange rates, which policy is more effective at changing output?

• A. Monetary policy
• B. Fiscal policy
• C. Both equally effective
• D. Neither effective

Answer: (B)

In this setup, the ability of policy to affect output hinges on how the fixed exchange rate and capital flows interact with policy tools. When the exchange rate is fixed and capital moves freely, changing the money supply to influence output is offset by offsetting capital flows and central bank actions aimed at maintaining the rate. In other words, monetary policy cannot reliably change the level of output because the exchange-rate commitment neutralizes its impact.

Fiscal policy, by contrast, directly shifts aggregate demand. A fiscal expansion raises income and demand for goods. The higher output attracts capital inflows due to higher returns, which would push the currency to appreciate if allowed. To preserve the fixed rate, the central bank intervenes by using foreign reserves to supply domestic currency, which expands the domestic money stock and supports the higher level of activity. This mechanism allows fiscal policy to raise output even with a fixed exchange rate.

So the more effective tool for changing output in a small open economy with fixed exchange rates is fiscal policy.