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Flexible exchange rates and contractionary fiscal policy Watch

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    So I am really confused when I'm looking at flexible exchange rates. If a country implemented contractionary fiscal policy then obviousy we would see a reduction in spending, fall in gdp, and fall in interest rate and imports would fall. How do I write about the exchange rate if it is floating though?
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    For currencies that are floating, their exchange rates are determined by the supply and demand for that currency so you simply need to look at how they're affected by contractionary fiscal policy. As you said, AD would fall and as you'd expect interest rates would fall, demand for that currency is likely to fall as well. That suggests a depreciative outlook for the currency.

    But there are a lot of other things which come into evaluating a question like this. For one, there's no hard rule that all currencies depreciate with contractionary fiscal policy. If you're exchanging one currency for another, it's logical that you also need to consider the relativity of that currency's behaviour. If another country cut its rates by a larger magnitude than the country in question, you may not get a significant depreciation because relatively speaking, hot money flows are still better off here where they can earn more. You also have other things like speculative behaviour which may not accurately reflect economic fundamentals, but sentiment instead.
 
 
 
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