Question

in a small open economy, starting from a position of a balanced current account (ca = 0), an increase in government spending (g) without a corresponding tax increase will lead to:

a current account deficit and a net capital inflow.

a current account deficit and a net capital outflow.

a current account surplus and a net capital inflow.

a current account surplus and a net capital outflow.

Explanation:

In a small open economy, when government spending (\(G\)) increases without a tax increase, the fiscal deficit rises. This leads to higher domestic interest rates (due to increased government borrowing or demand for loanable funds). Higher interest rates attract foreign capital (net capital inflow). Also, increased government spending (and potentially higher income from the multiplier effect) leads to higher imports, causing the current account (which includes net exports) to move into deficit (since \(CA = \text{net exports}\), and imports > exports when domestic spending rises). So the outcome is a current account deficit and net capital inflow.

Answer:

A. A current account deficit and a net capital inflow.