Describe the impact of contractionary fiscal policy (such as a decrease in government spending) upon Real GDP in both a closed economy and an open economy. In which type of economy would the change in Real GDP be greater?

Answer 1

In a closed economy, contractionary fiscal policy decreases aggregate demand, shifting the AD curve leftward, and lowering Real GDP. In an open economy, contractionary fiscal policy would cause a budget deficit to decrease, so the U.S. government would not need to borrow as much money. When the U.S. Treasury borrows fewer funds in the credit market, it reduces overall demand for loanable funds putting downward pressure on real interest rates. Lower real interest rates in the United States makes U.S. assets a less desireable investment, and foreign assets a more desireable investment. The dollar would thus depreciate and the foreign currencies would appreciate. The result would be a rightward shift in the U.S. AD curve and a leftward shift in the U.S. SRAS curve. Under typical conditions, a depreciated dollar feeds back into the domestic economy and pushes Real GDP upward. The net impact on Real GDP depends on how strong the international feedback effects are on the domestic economy. However, we can conclude that contractionary fiscal policy lowers Real GDP more in a closed economy than in an open economy.