Question

1. In the early eighties, under the Reagan administration, macroeconomic policies in the United States were characterized by relatively expansionary fiscal policy (fueled by increased defense spending and tax cuts) and very tight monetary policy. Compared to an alternative policy mix which produced the same level of Y using more expansionary monetary policy and more contractionary fiscal policy. Contrast the two different policy mixes graphically and in words. Explain what effects you would expect such policy mixes to have on each of the following:
   1. Interest rates in the United States.
   2. The real exchange rate of the U.S. dollar.
   3. The current account of the U.S. balance of payments.

Answer 1

Sol :

a) Expansionary Fiscal policy ( i.e increses in Government spending , decrease in tax) and tight or Contractionary monetary policy ( i.e increase in CRR , Fed Rate ) have no effect on Interest rate in the U.S because of the following points :

• As, Expansionary Fiscal policy will increase the net disposable income in the hands of the people , which increases the aggregate demand , consumpltion level. Due to which , Demand for the product exceeds the supply of the commodities , creating the situation of inflation in the economy. Moreover due to increase in net disposable income of the people, the money supply increases and demand for the loans from the bank reduces and interest rate falls .
• As, tight monetary policy means policy which tends to reduce the money supply in the economy by increasing the interest rate , reserve ratio etc. now , in this case , interest rate increases for the loans due to increase in reserve requirement by the bank .
• Impact : In part (i) Interest rate falls and in part (ii) interest rate incraeses . The net impact is zero on the interest Rate. As shown in the diagram below :

b) effect of expansionary fiscal policy and tith monetary policy on Real exchange rate is as follows :

• As, Expansionary Fiscal policy will increase the net disposable income in the hands of the people , which increases the aggregate demand , consumpltion level. Due to which , Demand for the product exceeds the supply of the commodities , creating the situation of inflation in the economy. Due to inflation , price level increases and product in the U.S becomes costlier than the product in the foreign country so , people in the U.S will prefer to import the goods from the other country . DUe to incraese in Imports and constant exports , Foriegn Exchange rate will increase or depreciates the U.S $
• As, tight monetary policy means policy which tends to reduce the money supply in the economy by incraesing the interest rate , reserve ratio etc. now , in this case , due to less money circulation decrease , aggregate demand for the product decreases and due to excess supply over demand , price will fall. so , in this case , product become cheaper than the rest of wolrd , so , Exports increases which will decrease the exchange rate means appreciates the U.S $
• Impact : (i) Exchange Rate increase (ii) Exchange rate decreases . The net impact will be no effect on the exchange rate of the U.S.

(c) Impact of Expansionary fiscal policy and contractionary monetary poicy on current Account is as follows :

• As, Expansionary Fiscal policy will increase the net disposable income in the hands of the people , which increases the aggregate demand , consumpltion level. Due to which , Demand for the product exceeds the supply of the commodities , creating the situation of inflation in the economy. Due to inflation , price level increases and product in the U.S becomes costlier than the product in the foreign country so , people in the U.S will prefer to import the goods from the other country . Due to increase in Imports , the Current A/c surplus decreases or becomes deficiet.
• As, tight monetary policy means policy which tends to reduce the money supply in the economy by incraesing the interest rate , reserve ratio etc. now , in this case , due to less money circulation decrease , aggregate demand for the product decreases and due to excess supply over demand , price will fall. so , in this case , product become cheaper than the rest of wolrd , so , Exports increases which will increase the current A/c surplus .
• Impact : (i) Current A/c Deficit (ii) Current A/c Surplus . The net impact is zero or no effect on current A/c of the U.S