Question

In: Economics

In April 1995, Michel Camdessus, managing director of the International Monetary Fund (IMF), criticized U.S. economic...

In April 1995, Michel Camdessus, managing director of the International Monetary Fund (IMF), criticized U.S. economic policy for allowing the dollar exchange rate to fall too low. He recommended that the U.S. reduce its budget deficit in order to raise the real exchange rate.

Use the Classical model for a small open economy with perfect capital mobility to answer Q2., so that the world interest rate (r*) equals the domestic interest (r). You may assume the economy begins with a position of balanced trade, NX = 0.

  1. Using the loanable funds market model illustrate and explain the effect of reducing the government's budget deficit on net capital outflows (NCO = NX). Make sure to label the axes and curves.

  2. Now, using the foreign exchange market diagram (S-I=NX), illustrate the impact of reducing the government's budget deficit on the real exchange rate and the net exports (NX). Make sure to label the axes and curves.

  3. Based on your answer in part 2, explain whether Mr. Camdessus's policy recommendation will work. Specifically explain what happens to the real exchange rate and the trade balance as a result of the government budget deficit reduction.

Solutions

Expert Solution

Government budget deficits have been the norm in the US since the 1960s. This pattern was broken down for a short period during the second Clinton administration when the US government ran a budget surplus. Tax cuts in 2001 plus spending on the second Gulf War put the federal budget back into serious deficit. Over the long sweep of history, the federal government typically ran surpluses in peacetime and deficits during wars. In contrast to the US, a number of other countries have moved from deficit to surplus as their budget norm. Canada is notable in this regard.
The budget deficit on which the media and politicians focus is the federal budget deficit, which in 2005 was $309 billion, or around 2.5 percent of GDP. "Government" in the national income accounts consists of all levels of govt-federal, state and local. State and local govts. tend to run small (less than 1 percent of GDP) surpluses in boom years and small deficits in recession years. In 2005, the state and local deficit was $3.3 billion, about 0.03 percent of GDP.
The main fear is that the govts. borrowing makes it difficult for private firms to borrow and invest and thus slows the economy's growth.
Measuring the federal deficit is complicated by the fact that most of the deficit can be accounted for by interest payments on the national debt. So most of the deficit represents not the excess of current spending over revenues but the legacy of past deficits.
Total deficit = primary deficit + interest payments.
In the figure the primary deficit clearly was higher in the 1980s and the early 1990s than it was during the 60s.
When interest payments are large, as they are in US, proper emasurement of the deficit is complicated by the distinction between real and nominal interest rates. Since the nominal interest rate equals the real interest rate plus inflation, interest payments on the debt can be divided into real payments and payments due to inflation The later do not cost the govt. anything in real terms, because they are exactly offset by the decrease in the real value of nominal debt. During periods of high inflation most of the interest payments are offset by inflation. Even during periods of low inflation, nearly half the interest payments may be offset in this way.

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