Question

he government in a small open

economy is concerned that the current account deficit is too high. One group

of economic advisers to the government argues that high government deficits

cause the current account deficit to be high and that the way to reduce the

current account deficit is to increase lump sum taxes. A second group of

economic advisers argues that the high current account deficit is caused by

high domestic investment and proposes that domestic investment should be

taxed, with these investment taxes returned to consumers as lump-sum

transfers.

a) Which advice should the government take if its goal is to reduce the

current account deficit? Explain.

b) Is the government’s goal of reducing the current account deficit

sensible? Why or why not? What will happen if the government takes

the advice that achieves its goal, as in part (a)?

Answer 1

a) The government should reduce the high domestic consumption and investment on imports through higher taxes .

The fiscal policy that the government can adopt is higher income tax which will reduce the domestic consumption and investment on imports.Higher income tax will increase the finances of the government.

b)The current account deficit which is also known as trade deficit shows imbalance between imports and exports.This appears to be a net loss for the US because dollars are used to import goods from foreign countries like using dollars to purchase Sweden cars and so US becomes poorer. It is argued that Americans should consume their own product rather than purchase from foreign countries.This is only the short term view. The long term view is that trading with foreigners is good from economic point of view.Americans buy foreign goods with American dollars and the foreigners invest American dollars earned in purchasing American goods and investing in American securities.Investments thus come back to American companies and leads to economic growth.So the government is not sensible .

If the government follows the policy in a)this will reduce aggregate demand and lead to less economic growth and unemployment.So the government would not like to risk higher unemployment and less growth.