Question

True or false: A larger current account deficit cannot occur unless the government budget deficit increases or households save less. Briefly explain your answer. Explain the results of a contractionary fiscal policy implemented in a fixed exchange rate regime economy

Answer 1

• True

As increase in budget deficit in an open economy tend to increase its domestic interest rate, which result into capital inflow causing real exchange rate appreciation. This appreciation in turn, deteriorates the current account deficit.

Also when household save less, current account deficit widens as government borrow more which result into greater dependence on extra budgetary resources and gap is funded by external sources.

Results of contractionary fiscal policy in a fixed exchange rate system -

Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments or increment in taxes.

In a fixed exchange rate system, contractionary fiscal policy will cause a decrease in Gross National Product. It will cause current account balance to rise. Thus, causing increase in trade surplus and a decrease in trade deficit. There will be no change in the exchange rate in the short run.