Question

2. Consider a small open country (Veniceland) with flexible exchange rate and perfect capital mobility. The economy is at the short-run equilibrium, and the domestic and foreign bonds pay the same interest rate. The government aims at increasing households' consumption to stimulate an economic recovery. Which policy should the government adopt? [2p] a. b. Explain the main economic adjustments leading to the new short-run equilibrium income and interest rate. [4p] How does the policy of the government affect the balance of trade? [2p] C. d. Consider the new equilibrium of the economy. An investor has to decide if buying domestic or foreign bonds. Which one should she chose? Justify your answer. [2p] A foreign investor owned Veniceland bonds before the (unexpected) government policy action. Does the financial wealth of the foreign investor change after the policy intervention of the government? If yes, how? [2p] e.

Answer 1

1. The flexible exchange rate system means a system where the forces of demand and supply –meaning the demand for the currency in the international market and its supply , determine the rate at which it can command units of other country’s currencies.

Since the government is aiming to stimulate household consumption which is an indicator that the planned aggregate demand is less than the planned aggregate supply, the government should adopt an expansionary policy, through fiscal measures, through the intervention of the Central bank and through a suitable foreign trade policy. It can undertake the following measures:

It can reduce taxes especially direct taxes and thereby increase disposable income in the hands of the households.

It can also increase its public expenditure which will have a great impact on boosting the household spending.

Similarly. The lending rates of banks especially for loans taken by households should be reduced.

In addition , the government should undertake exports improvement or export encouraging policies. These will increase demand for domestic goods in the international markets.

b. The newer short run equilibrium will regain at a higher level since an increase in household expenditure will improve the situation of deficient demand ( or lower household consumption expenditure) in the economy , An increase in expenditure ( and investment ) by the government will lead to increase in consumption expenditure by households, it will increase the income levels and the equilibrium will shift to a newer position. The ability to consume or the power of the households to spend more on consumption expenditure rises as income levels rise and this further multiplies into spending by other economic entities—households spend on goods and services which re produced by firms who will invest and produce more goods and services on observing the positive indications from the market.

It will lead to a gradual rise in the interest rates since money will be demanded for speculative purposes by the households ( consumers will start investing ins shares, bonds, firms will also need money for investment purposes and hence the interest rates will be likely to rise. Since perfect capital mobility is assumed , there will be free flow of investment towards those arenas that are likely to fetch higher returns.

The government can try to induce investors to invest ( short run investment ), especially from abroad by raising the domestic interest rate and having an investor friendly policy.

c. The balance of trade is a statement showing the balance of exported goods and imported goods. The government’s policy to stimulate economic recovery , will affect the relative prices of goods exported as well as imported. Increased income levels will stimulate the demand for imports though the demand for exports depends upon the income levels in the ‘rest of the world’ sector, meaning the income levels in other countries that are engaged in trade with Veniceland.

d. The newer equilibrium that is regained due to a policy of stimulation of growth in the economy by seeking to increase consumer or household spending will be at a higher level than the previous one since the increased incomes   are assumed to increase the propensity of the households to spend more on consumption expenditure. However it has to be noted that if the households do not spend to the extent envisaged then the amount of income that has been generated by such a policy will be much less.

Since Veniceland is an open economy engaging in international trade, government policy to stimulate the household demand will act as a boost to the flow of income levels, exports will improve but imports will also rise since the real income of the people will rise and they would want to buy more goods whether within the country or abroad. Along with rising ability to spend , the speculative demand for money will also rise.

The investor will be better off buying bonds in the domestic market since the increased income levels will have increased interest rates , and the growth stimulating policies will attract foreign investors towards the domestic market.

e. The rising income levels as a result of the policy of the government to stimulate economic growth will have expansionary effects on the income output and employment levels in the economy. The rise in households consumption expenditure will have a multiplier effect on the other entities of the economy—hence the producers will now want to increase their investments, rise in investment will increase interest rates, the foreign investor’s financial wealth will also change since the rise in interest rates ( the reward for capital ) will be more than in the international scenario. Since perfect capital mobility has been assumed , Veniceland’s government policy will attract foreign investors who will want to invest in Veniceland.