In a small open economy with flexible exchange rate, short run expansionary fiscal policy raises interest rates, currency appreciates; what is net effect on net exports?

• A. Exchange rate depreciates; Net exports rise
• B. Exchange rate appreciates; Net exports fall
• C. Exchange rate remains fixed; Net exports unchanged
• D. Exchange rate appreciates; Net exports rise

Answer: (B)

In a small open economy with flexible exchange rates and capital mobility, expansionary fiscal policy raises aggregate demand and, in the short run, pushes up the domestic interest rate. Higher interest rates attract capital inflows, increasing demand for the domestic currency and causing its value to rise—the currency appreciates. An appreciating currency makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic residents, so exports fall and imports rise, driving net exports down. Therefore, the exchange rate appreciates and net exports fall.