How will an increase in federal government spending without an increase in taxes affect real GDP and the price level in the short run in a closed economy and in an open economy?

Question

What will be an ideal response?

Answer 1

In a closed economy, an expansionary fiscal policy directly increases aggregate demand, leading to an increase in real GDP and in the price level. An expansionary fiscal policy also results in the crowding out effect as higher interest rates lower domestic investment and purchases of consumer durables. In an open economy, an expansionary fiscal policy also directly results in an increase in aggregate demand and, therefore, an increase in real GDP and in the price level. However, in addition to lower domestic investment, higher interest rates in an open economy also lead to an increase in the country's foreign exchange rate (when stated in terms of foreign currency per domestic currency), which decreases net exports. The crowding out effect in an open economy is therefore larger than in a closed economy.