Question

1. If a country faces a trade deficit,
   1. What fiscal policy would you propose to reduce the trade deficit?
   2. What monetary policy would you propose?

2. What fiscal, monetary, and exchange rate policies would you propose if a country wanted to eliminate a trade surplus so that its citizens would have access to more consumer goods?

3. Explain what is lilkely to value of the dollar if the following economic conditions change. (You can use a supply-demand drawing or reason with words.)

1. The Federal Reserve decides to lower interest rates.
2. A crisis causes foreign holders of finance to buy safe assets.
3. A big economic expansion in Europe leads to a surge of demand for American exports.
4. The United States experiences a big economic expansion and this leads to an increase in the demand for imports from China.

Answer 1

Answer 1:

a. To reduce trade deficit in the country, the currency should depreciate so that Net exports of the nation increases which will reduce trade deficit of the nation. A currency will depreciate if the rate of interest falls because it leads to Net capital outflow from the economy. Thus, in order to decrease the rate of interest, the government should follow contractionary fiscal policy which involves reducing government expenditure and increasing tax rate which will shift IS curve leftwards and lead to fall in the rate of interest. Thus, contractionary fiscal policy is needed to reduce trade deficit in the nation.

b. In order to reduce the rate of interest, expansionary monetary policy is needed because increase in money supply reduces rate of interest which leads to currency depreciation and thus lead to increase in Net exports and trade balance of the nation.

c. In order to eliminate trade surplsu in the economy, appreciation of exchange rate with increased level of rate of interest is needed. This involves use of expansionary fiscal policy and contractionary monetary policy which leads to increase in the rate of interest and net capital inflow in the econonmy leading to appreciation in the value of currency which in turn reduces trade surplus in the economy.