Question

Describe the effects of contractionary fiscal policy by the domestic government on output, the real interest rate, and net exports in both the domestic and foreign country, using a Keynesian model.

Answer 1

Answer: When there is a low unemployment however inflationary rises in the price level are a concern the Keynesians would pursue contractionary fiscal policy. Contractionary fiscal policy includes increase in taxes or reduction in government spending designed to reduce the aggregate demand and decrease the inflationary pressures. It will cause downward pressure on the price level, however a very little fall in output or very little increase in unemployment. The net exports increases in the domestic country and falls in foreign country. To summarize,

Domestic country: real interest rate falls, output falls, and net exports increases.

Foreign country: real interest rate falls, output falls, and net exports decreases

Answer 2

In a Keynesian model, contractionary fiscal policy refers to the government's actions to reduce its budget deficit or increase its budget surplus in order to cool down an overheating economy and control inflation. The main tools used for contractionary fiscal policy are decreasing government spending and/or increasing taxes. Let's examine the effects of contractionary fiscal policy on output, real interest rates, and net exports in both the domestic and foreign countries:

1. Output:

• Domestic Country: Contractionary fiscal policy leads to reduced government spending and/or higher taxes, which results in decreased aggregate demand. As a result, businesses may experience a decline in demand for their goods and services, leading to a decrease in output or real GDP. The level of employment may also decrease as businesses respond to reduced demand by cutting back on production and hiring fewer workers.

• Foreign Country: The decrease in output in the domestic country can have spillover effects on the foreign country if it is a trading partner. Reduced demand for goods and services from the domestic country may lead to a decrease in exports from the foreign country to the domestic country, impacting the foreign country's output as well.

2. Real Interest Rate:

• Domestic Country: With reduced government spending and/or higher taxes, there is less government borrowing and a decrease in demand for loanable funds. As a result, the real interest rate in the domestic country may decrease. Lower real interest rates can encourage private sector investment and consumption, which may partially offset the negative impact on output caused by reduced government spending.

• Foreign Country: The decrease in demand for imports from the domestic country may also lead to a decrease in demand for the foreign country's currency, causing its exchange rate to appreciate. An appreciation of the foreign currency can reduce the competitiveness of the foreign country's exports, potentially impacting its output and growth.

3. Net Exports:

• Domestic Country: Contractionary fiscal policy can lead to a decrease in domestic demand, including demand for imports. With lower consumer spending and investment, imports may decrease. As a result, the trade balance may improve, leading to an increase in net exports (exports minus imports).

• Foreign Country: The decrease in imports from the domestic country can negatively impact the foreign country's net exports, as it relies on the domestic country as a market for its goods and services. A decrease in demand from the domestic country may lead to reduced exports to the domestic country, potentially affecting the foreign country's output and employment.

Overall, contractionary fiscal policy in a Keynesian model can have mixed effects on output, real interest rates, and net exports in both the domestic and foreign countries. The precise impact will depend on the specific economic conditions, trade relationships, and policy implementation.