Question

You are hired as part of a policy review team for the Council of Economic Advisers. Elected leaders whom the Council report to have put their highest priority on increasing U.S. GPD, but also don’t want a worse trade balance. The team leader designates you to develop a theoretically-based policy package that will improve U.S. GDP without worsening the trade balance. The U.S. is a large advanced economy with freely floating exchange rates.

a.) What combination of fiscal and/or monetary policy would you recommend to the Council? Your response should discuss both fiscal and monetary policy, even if your recommendation advises against using one or the other. You will be using and referring to the AS/AD model in constructing your recommendation.

b.) What would be the impact of the policy package that you recommend in (a) on the U.S.’s external trading partners including their GDP, their price level, and their trade balance (i.e., the transmission effect)? IMPACT ON *OTHER* COUNTRIES, NOT THE U.S.!

Answer 1

a) It is given that the U.S. is a large advanced economy with freely floating exchange rates. Leaders give highest priority on increasing U.S. GDP, but also don’t want a worse trade balance.

In an economy with free floating exchange rates, fiscal policy becomes ineffective. For example, an increase in government spending will increase GDP, but with an increased interest rate. A higher rate than rest of the world increases demand for dollars, so dollar appreciates. This reduces trade deficit in short term because value of exports seem more than value of imports, but over time the demand for american export falls due to its high value.

Monetary policy seems the most effective here. Increase in monetary policy lowers interest rate. So it increases investment and gives more money in people's hand to spend, so output increases. However, lower interest rate also depreciates the dollar. A depreciated dollar might look bad on trade accounts in short run because value of exports suddenly rises, but in the longer term, american exports rises due to depreciated currency.  So, monetary policy is recommended for maximum output and low trade balance. Expansionary monetary policy is expected to raise the price level, according to AS-AD model.

b) If US goes with expansionary monetary policy, then it will also affect the world interest rate since it is a large country. Other countries might also be forced to lower their home rates. A depreciated dollar simply means an appreciated currency of trading partner. So, imports of trading partner rises, which lowers their GDP and worsen their trade balance. As demand for their home goods fall, from AS-AD model we can predict that price level will also fall in the trading country.