Question

Quote from Greg Ip WSJ blog, “The Donald Trump Trade Effects: Watch the Peso, Not Ford” Mr. Trump’s fiscal and trade policies are in conflict. His plans to slash taxes and boost infrastructure spending will inflate the budget deficit and stimulate an economy already close to full employment.

(1) To prevent an outbreak of inflation, the Federal Reserve will raise interest rates more quickly, pushing the dollar higher.

(2) The combination of a stronger dollar and stronger domestic demand will curve exports and suck in imports, causing the trade deficit to widen.

(3) Using a combination of graphs and explanation, explain the reasoning behind this statement.

Answer 1

In his 2018 budget 'America First: A Budget Blueprint to Make America Great Again' proposal, made on 27 February 2017, President Trump has proposed tax cuts and boost in infrastructure spending.

In an economy which is already operating at full employment, tax cuts and increased spending (Congress has approved an approximate $300 billion increase in spending), the U.S budget deficit is expected to surpass $1 trillion by 2020, two years sooner than previously expected. Given that spending will be more than revenue, in the long-run, there will be an upward pressure on prices (leading to inflation). This will prompt the Fed to increase the interest rates to curb inflation.

As you can see from the graph of Price-Real GDP, when the economy operates at full employment, the long-run aggregate supply (LRAS) curve provides with real GDP Y. If we focus on SRAS (Short Run Aggregate Supply) curve, when Aggregate Demand is AD₀ , then the equilibrium output is E_0, and the price is P_0. When the government increases its spending, we can expect a rise in aggregate demand for goods and services in the economy. This will produce a shift in the aggregate demand curve to AD_1. There will be an increase in prices of goods to a higher price P_1.

(1) To curb inflation as explained above, the Fed will have to raise the interest rates. An increase in interest rates will reduce the dollar supply in the economy vis-a-vis the demand for the dollar. This will, in turn, make the dollar stronger.

(2) When taxes are low, public spending is high, people have additional money to spend. This combined with the stronger dollar (as seen in point 1), will increase the demand for goods and services. Since the economy is already operating at full employment, we cannot expect an increase in Short-Run Aggregate Supply of goods and services. This implies an increase in demand for foreign goods.

Since the dollar is stronger, US imports will be cheaper than US exports. The below graph shows how when a currency gets stronger, imports are more than exports. Ignore the currency being GBP. We can assume the graph in USD.

When currency becomes stronger, the quantity of exports reduces from Q1 to Qx and quantity of imports increases from Q1 to Qm. Thus creating a gap between the blue line of imports and the red line of exports.

Since Greg Ip's blog mentions Peso, a strong dollar will imply imports from Mexico in Peso, will get cheaper and exports to Mexico in the dollar will reduce as these have become more expensive. More imports from Mexico and reduced exports to Mexico will further widen the U.S-Mexico Trade Deficit.

For 2018 till March, US-Mexico trade deficit stands at $18.3 mn.