Question

In the case of a small open economy with fixed exchange rate regime and imperfect capital mobility, which of the following is/are CORRECT?

• A. Fiscal contraction will lead to Balance of Payment deficit in the short-run if the slope of LM curve is greater than the slope of Balance of Payment curve
• B. Fiscal contraction will lead to Balance of Payment deficit in the short-run if the slope of LM curve is less than the slope of Balance of Payment curve
• C. Monetary expansion leads to Balance of Payment surplus in the short run irrespective of the slopes of the LM curve and the Balance of Payment curve
• D. Monetary expansion leads to Balance of Payment deficit in the short run irrespective of the slopes of the LM curve and the Balance of Payment curve

Answer 1

The Correct Option is A, D

Impact of Fiscal and Monetary Policies in a Small Open Economy with Fixed Exchange Rates

In a small open economy with a fixed exchange rate regime and imperfect capital mobility, the following observations hold:

Option (A): Fiscal Contraction and Balance of Payment Deficit

• Correct. Fiscal contraction reduces income, shifting the IS curve leftward. 
• If the LM curve is steeper than the BP curve, the decrease in income and interest rate adjustments cause a Balance of Payment (BoP) deficit in the short run.

Option (B): Fiscal Contraction and Balance of Payment Deficit when LM is Flatter than BP

• Incorrect. If the LM curve is flatter than the BP curve, fiscal contraction does not necessarily lead to a BoP deficit.
• The economy may stabilize in a different manner depending on the capital mobility and interest rate adjustments.

Option (C): Monetary Expansion Leads to Balance of Payment Surplus

• Incorrect. Under a fixed exchange rate, monetary expansion causes pressure for currency depreciation.
• The central bank intervenes by selling foreign reserves to maintain the exchange rate, leading to a BoP deficit, not a surplus.

Option (D): Monetary Expansion Leads to Balance of Payment Deficit

• Partially Correct. Monetary expansion generally results in a BoP deficit under a fixed exchange rate regime.
• However, the outcome is not completely independent of the slopes of the LM and BP curves, as factors such as capital mobility and interest rate changes also play a role.

Conclusion:

The correct statements are:

• Option (A): Fiscal contraction leads to a BoP deficit if the LM curve is steeper than the BP curve.
• Option (D): Monetary expansion leads to a BoP deficit under a fixed exchange rate.