How is the impact of expansionary fiscal policy different in an ...

[stevenposner]

How is the impact of expansionary fiscal policy different in an open economy than in a closed economy?
 
  What will be an ideal response?

Question 2

President Bush lowered taxes on capital gains and dividends in 2003. Explain how this might increase aggregate supply.
 
  What will be an ideal response?

[Jordin Calloway]

Answer to Question 1

In a closed economy, expansionary fiscal policy raises aggregate demand through higher government spending. If the higher spending level is financed by government borrowing, this increase in the deficit raises interest rates and crowds out private consumption and investment. However, the direct effect of higher government spending is strong enough to result in an increase in aggregate demand.
In an open economy, however, the higher interest rate that results from an increase in the deficit also raises exchange rates, which will reduce net exports. Since net exports are also a component of aggregate demand, the impact of expansionary fiscal policy in increasing aggregate demand is more limited in an open economy than in a closed economy.

Answer to Question 2

A lender earns a capital gain if she purchases an asset such as a stock at a particular price and then sells it later at a higher price. This difference in price is the capital gain, and is subject to taxes. If capital gain taxes are lowered, the after-tax rate of return on stocks will rise.
Dividends are corporate profits that get redistributed to stock shareholders. These are taxed, and the lower the tax, the greater the after-tax rate of return to investing in a stock that pays a dividend.
Increasing this after-tax rate of return will increase the household's willingness to save and raise the supply of loanable funds. This will lower the interest rate and encourage firms to purchase new capital. This increases the capital stock and aggregate supply.