In a small open economy with a floating exchange rate,

Solution

As G increases, IS 1 shifts to IS 2 . At new equilibrium e', interest rate also increases and i > i*. Here,2 things are happening: a) there will now be capital inflow as a result capital A/c surplus b) Since, AD and Y increased, import demand will increase which will lead to current A/c deficit. Since, the magnitude of Capital A/c surplus will be much higher than the magnitude of current A/c deficit; there is BOP surplus. As a result domestic currency appreciates; dd for rupee has increased. So, there will be capital inflow which will bring back the interest rate to its original level. As a result, exports decrease and Imports increase (imports have become cheaper) [Net exports falls] IS shifts back to initial level and equilibrium in the goods market is restored. In a small open economy with a floating exchange rate, the supply of real money balances is fixed and a rise in government spending cannot change the interest rate so that net exports must fall to maintain equilibrium in the goods market.