Question

Suppose a small open economy has a floating exchange rate and the government reduces spending. What will happen to real income in the short run?

Answer 1

Less government spending will make the currency value of the small country to fall compared to other currencies, because less government spending means less printing of money, and a slower growth of the money means less inflation, and a cheaper currency.

This will make the exports of the small open economy attractive, leading to an increase in this component of aggregate demand. Such scenario will result in a rise of real income in the short run.