Question

The economy of one of our major trading partners is booming. As a consequence, demand for our exports is at an all-time high. Explain how this development threatens our country’s internal and external balances. Design a policy mix, fiscal and/or monetary, aimed at restoring both internal and external balance.

Answer 1

When demand for exports rises , the aggregate demand rises in our economy since net exports are a part of AD ( Net exports = Export - Import ) . This also causes high demand for domestic currency to buy those exported goods . Thus this improves trade balance . And the demand for domestic currency in foreign markets leads to stronger currency or appreciation of currecy . So external balance is not threatened immediately . But continuous appreciation makes our currency expensive to other partners in trade which can worsen trade balance in long term . So to avoid this we should take up a policy of pegging or fixing exchange rate and not follow floating exchange rate policy .

Now rise in AD causes inflationary gap which leads to rise in prices and actual output > potential output . This can be tackled with either contractionary monetary or fiscal policy or both . The best way is to promote contractionary fiscal policy because this does not affect production , rather reduces domestic consumption demand by raising taxes . So that maximum output or production that is being exported is balanced out by fall in domestic consumption demand .