Question

Countries A and B are small open economies. Their economies depend on each other heavily for trade, but their respective governments don't always work together when setting economic policy. Assume (for simplicity) that these countries only trade with each other. Country A decides to decrease domestic taxes to balance its budget. a) How does Country A's policy, assuming they have a floating exchange rate, immediately impact trade between the two countries? Explain your answer with graphs and two sentences. b) Now assume Country B pegs their currency (fixed exchange rate) to Country A's currency. How should Country B's central bank respond to Country A's policy to control short run output? How does Country B’s new policy impact trade relative to before Country A changed their tax policy? Explain your answer with graphs and two sentences. c) Suppose Country A’s central bank contracted money supply to combat inflation simultaneously with their new tax policy (explained before part (a)). With this new information. Would your answer in part (b) change for Country B’s optimal central bank policy to fix their exchange rate? Explain your logic.

Answer 1

a) So country A exhibits a floating exchange rate. This policy of decreasing domestic taxes is a kind of expansionary fiscal policy. These expansionary fiscal actions are aimed at increasing the government balance deficit or decreasing the baudget surplus. Now, suppose the economy is initially in the equilibrium J, and the Gross National Product or GDP is at Y0 and and the exchange rate is at E0. Now, as the taxes are reduced,, more amount of disposable income is in the hands of the consumers, thus increasing the aggredate demand in the economy. So, this shifts the IS curve to the right. The LM remains unchanged. The new equilibrium thus shows a higher level of GDP. The increase in domestic output, or GNP increases the real money demand. With a higher interest rate, there is an appreciation of the domestic currency and a decrease in the exchange rate. So, the fall in the exchange rate implies that the currency of country A is worth less as compared to country B. So, the exports will become cheaper and imports will become expensive. So, there will be an increase in the quantity of exports and decrease in the quantity of imports. Take a look at fig 1.

b) Now, if country B fixes its exchange rate to country A's and follows a fixed exchange rate regime, under fixed exchange rate, the domestic interest rate has to be equal to the foreign rate. And the money supply has to be adjusted to maintain teh exchange rate at the fixed level. Now, the fall in the exchange rate as the exchange rate of country A falls, country B cannot let its currency appreciate as it will make the domestic interest rate rise over the foreign interest rate. So, as the increase in output causes an increase in demand for money, the central bank of country B must accomodate this by increasing the money supply. So, the LM curve is shifted down as the IS curve shifts to the right, which will maintain the same interest rate and same exchange rate. However, there will be a higher output or GDP. Take a look at fig 2. So, keeping a low exchange rate due to the pegged exchange rate will help to ensure country B's product's competitiveness abroad and profitability at home.

c) Now, in country A, under floating exchange rate, along with the tax policy, if there is a contraction or decrease in the money supply, so along with the rightward shift of the IS curve, there is an upward shift of the LM curve. There is an increase in the interest rate, and increase in the exchange rate, the output remains almost unchanged. Take a look at fig 3. So, in this case, the policy taken by country B to fix the exchange rate is not the same as the one in part (b) as there is an increase or revaluation of exchange rate. So, the answer should change. In order to maintain its exchange rate, the central bank of country B will buy or sell its own currency on the foreign exchange ForeX market in excahnge for the currency it pegged to, in this case currenc of country A.