Question

You are the economic advisor of a hypothetical country Macronesia. You country has big current account deficit, inflation and unemployment problems
a) Explain what kind of monetray policy do you recommend the Central Bank of Macronesia to follow.
b) Explain what kind of fiscal policy do you recommend the Central Bank of Macronesia to follow.
c) What would be the impact of your recommended policies on interest rate and exchange rate.

Answer 1

a)

For curbing current account deficit, the central bank needs to follow monetary policies like:

• Increasing the prices of imports and reducing the price of exports to gradually cover up the current account deficit. This is nothing but a process to devalue the exchange rate.

When Macronesia experiences both inflation and unemployment (which are often inversely correlated), we say that the country is undergoing stagflation. This poses an unique challenge for the policy makers to control this scenario. So policy makers take decisions for the long run benefits at the cost of putting the country in a short term hardship.

• Monetary policies are made to reduce inflation by increasing the interest rates, but this further more puts more people out of jobs. So, the government tries to reduce the dependency on oil and related industries, as oil is one of the primary causes of stagflation

b)

To reduce the current account deficits, the central bank deploys the following fiscal policy:

• Decreasing the domestic consumption on foreign goods (imports). This is done by increasing the taxes thereby deploying a tight fiscal policy.

As far as the stagflation is concerned, the only remedy is to rebound the economy after a brief recession caused due to the policies suggested in a).

• Supply side needs to be maintained at highly competitive levels to ensure that the productivity increases which can manage inflation, and the competitiveness ensures the jobs are available for the unemployed.
• Regulations of prices in the market to ensure that inflation is at acceptable levels.

c) The exchange rate decreases because of the devaluation caused by implementing these policies. And on the other hand, the interest rates increase due to the government's policy perspective of reducing inflation and unemployment at the same time. Stagflation is a very critical situation where no country wishes to be in. A complex framework is created to curb the situation and there is no universally agreed upon remedy to this.

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