Rutgers Introduction to Macroeconomics Practice Test

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.