Question

II. Consider an open economy with flexible exchange rates. Suppose output is at the natural level, but there is a trade deficit. The goal of policy is to reduce the trade deficit and leave the level of output at its natural level. What is the appropriate fiscal and monetary policy mix?

Answer 1

Answer:

When imports are more than exports then the trade deficit occurs. To reduce trade deficit government should persue both expansionary monetary policy and contractionary fiscal policy and still maintain output at its natural rate that is potential GDP. The potential GDP is achieved when expansionary monetary policy balances with contractionary fiscal policy.

Expansionary monetary policy will increase money supply which are lower interest rates. To enjoy high returns lower interest rate in domestic country than world interest rate will make local investors to shift their investments from domestic country to foreign countries. So this will increase demand for foreign currencies making domestic currency to depreciate. Home country depreciation make domestic goods amd services relatively cheap when compared to foreign goods amd services. Thus increases exports and helps to reduce the trade balance.

Contractional fiscal policy such as reduced government spending or taxes increasing will decrease money supply in the economy. The decrease in money demand leads to capital flow and interest rates will decrease. Imports will be reduced when the currency depreciates and the trade balance also reduces. This will make increase in aggregate supply because of increase in foreign demand for domestic goods and services. This will make output to remain potential GDP.