Question

Consider an open economy with flexible exchange rates. Suppose that policy makers are happy with the level of output (unemployment is at the natural rate) but that a large trade surplus has been provoking complaints from other countries.

What kind of fiscal and/or monetary policy would you recommend in order to reduce the trade surplus while keeping output unchanged?

Answer 1

Trade surplus occurs when exports > imports. To reduce trade surplus, exports have to be reduced or imports have to increase.

Aggregate Demand = Consumption + Investment + Government Spending + Exports - Imports

If Exports have to fall or Imports have to rise, aggregate demand will fall in both the cases. Government can adopt contractionary fiscal policy to reduce aggregate demand in the economy which will shift aggregate demand curve from demand to new demand,

Fed should adopt expansionary monetary policy with it such that money supply in the economy rises by reducing rate of interest. Reducing rate of interest will help producers in producing more because it reduces their cost of production. It shift supply curve from supply to new supply.

After combination of both these policies, new equilibrium is shifted from point E to E2 where price will fall from P* to P2 while output remains at the same level of Y*.