Question

Suppose an economy under fixed (pegged) exchange rates is currently facing:

• a balanced current account (NX = 0),

• a negative output gap (excess unemployment), and

• a balanced budget.

• Using an NX/ (S-I) model depict the above situation in relation to the internal and external balance diagrammatically.

• Now suppose as an advisor to the government your recommendation is to employ an expenditure-changing policy to attain the Internal Balance. Explain in details what this policy is made up and what the consequences of your recommendations will be. Show diagrammatically and explain fully.

• In light of your answer above would you agree with this statement? “A trade deficit and low savings go hand in hand.” Evaluate fully.

• Defend this proposition “attaining the two policy objectives of internal and external balance requires two polices”. Explain and illustrate diagrammatically.

Answer 1

In an open economy a policymakers need to achieve two macroeconomic goals, these are Internal Balance and External Balance. Internal Balance is a situation in which an economy is at its potential level of output, that is it maintains the full employment of resources given the available technology.

Expenditure changing policy change the level of domestic spending, that interns change the output as well as employment. Here the equilibrium condition is given below. Expenditure changing policy includes “fiscal policy” or “monetary policy”.

=> Y = C + I + G + (X-M), => Y = C + I + G + NX, => Y – C – I - G = NX, => Y – C – I - G + T – T = NX.

=> (Y –T – C) – I + (T – G) = NX, where are “(Y-T-C) = Private Savings”, “(T-G) = Public Savings”.

=> S – I = NX, where are “S = (Y-T-C) + (T-G) = Nation Savings”, sum of private and public savings.

So, here at the equilibrium the “NX=Net Export” must be equal to the “S-I = Excess of Savings over Investment”. Consider the following fig shows the NX and “S-I”.

Here the NX is negatively related to income, => as the income increases that increases the import but the export will not change, => the NX decreases. So, the NX is negatively related to income. Now, the “S-I” is positively related to income. So, the initial equilibrium is at E1, where NX1 and (S-I)1 cross each other, => the equilibrium level of income is Y1 where NX=0, but it is below the full employment level of output.

If a policy make takes expansionary fiscal policy by increasing “G”, that decreases the national savings, => (S-I) decreases given the level of output. So, the (S-I) will shift downward side. So, the new equilibrium is E2 where NX1 and (S-I)2 cross each other. Here the equilibrium level of income is exactly equal to the potential level of income but net export become negative, => there is not external balance.

So, the given statement is TRUE.

Now, if the policy maker taker “expenditure switching policy” along with “expansionary changing policy” then the NX function will also shift to the right side. So, both the “Internal and External Balance” are achieved. So, the given statement is also TRUE.