Question

How does expansionary fiscal policy abroad affect r, CF, e, NX, and Y in the short-run, under floating exchange rates in a large open economy?

Answer 1

Answer :

Expansionary Fiscal Policy :

Suppose the economy is originally at a superequilibrium shown as point J in Figure below "Expansionary Fiscal Policy in the AA-DD Model with Floating Exchange Rates". The original gross national product (GNP) level is Y¹ and the exchange rate is E_$/£¹. Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). "Shifting the DD Curve", fiscal policy changes cause a shift in the DD curve. More specifically, an increase in government spending (or an increase in transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., ↑G, ↑TR, and ↓T all are DD right-shifters). This is depicted in the diagram as a shift from the red DD to the blue D′D′ line.

Expansionary Fiscal Policy in the AA-DD Model with Floating Exchange Rates :

There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness: first the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

The increase in DD causes a shift in the superequilibrium point from J to K. In adjusting to the new equilibrium at K, GNP rises from Y¹ to Y² and the exchange rate decreases from E_$/£¹ to E_$/£². The decrease in the exchange represents a decrease in the British pound value and an increase in the U.S. dollar value. In other words, it is a depreciation of the pound and an appreciation of the dollar. Since the final equilibrium point K is below the initial iso-CAB line CC, the current account balance decreases. If the CAB were in surplus at J, then the surplus decreases; if the CAB were in deficit, then the deficit rises. Thus the U.S. expansionary fiscal policy causes an increase in the U.S. GNP, an appreciation of the U.S. dollar, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.