Question

7. Describe the mechanism that leads from a change in fiscal policy to changes in interest rate, and the current account balance. Do the same for monetary policy.

Answer 1

ans....

When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the United States than they buy from it and, in return, acquire ownership of U.S. assets (including government debt). In the long run, however, the accumulation of external debt that results from persistent government deficits can lead foreigners to distrust U.S. assets and can cause a deprecation of the exchange rate.

Monetary policy involves altering base interest rates, which ultimately determine all other interest rates in the economy, or altering the quantity of money in the economy. Many economists argue that altering exchange rates is a form of monetary policy, given that interest rates and exchange rates are closely related.

The monetary policy transmission mechanism is the process by which changes in the settings of monetary policy instruments lead to the desired changes in inflation. The first stage in the transmission mechanism is therefore a change in the settings of monetary policy instruments. This engenders a change in the behaviour of the intermediary markets which the monetary policy instruments directly influence. The change in behaviour on these markets in turn leads - via changes in various other intermediary markets - to changes on the target markets where the central bank wants to influence inflation.

The transmission mechanism acts through several channels in parallel. The traditionally quoted example is the interest rate channel, which operates in the following way. An increase/decrease in a monetary policy interest rate leads first to an increase/decrease in interest rates on the interbank market. This in turn causes banks to raise/lower their rates on credits and deposits. The result is a contraction/expansion of investment activity and aggregate demand and ultimately a weakening/strengthening of inflationary pressures.