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Fiscal Policy, Fixed Exchange Rates, and High Capital Mobility

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Analyze the following statement: "Given an open economy with high capital mobility, fiscal policy is strengthened under fixed exchange rates."

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The statement is true.
refer to the attached graph to support the explanation, where:
r = interest rate
Y = income
LM = LM curve
IS = IS curve
BP = balance of payment

With fiscal policy expansion, IS will shift to IS'. Both interest rate and income increase to ...

Solution Summary

Fiscal policy will be effective under the fixed exchange rate regime with high capital mobility. Initial increment in interest rate as a result of fiscal expansion, will attract more capital inflows. This capital inflow will be more than enough to finance higher imports resulting from higher income due to fiscal expansion. The overall balance of payment will be in surplus. High level of capital will drag down the interest rate. Investment will increase and income will further increase. Therefore, in total the increment in income is higher than the normal case of fiscal expansion in a closed economy, or in the open economy with low capital mobility.