Question

Consider the short-run impact of the U.S. fiscal policy action on the economy of Mexico, a small open economy with a floating exchange rate against the U.S. dollar. What is the impact of the U.S. fiscal policy action on consumption, investment, and the unemployment rate in Mexico? Explain.

Answer 1

Case 1: Expansionary Fiscal Policy in the US

Consumption will increase, and unemployment and investment will fall in Mexico in the short run.

Case 2: Contractionary Fiscal Policy in the US

Consumption will fall, and unemployment and investment will increase in Mexico in the short run.

Explanation:
Given that there is a floating exchange rate system between the US and Mexico.

Fiscal policies are those policies that are controlled by the government in order to achieve policy aims. It can be either expansionary or contractionary policy.

Case 1: Expansionary Fiscal Policy in the US

An expansionary fiscal policy, when the government either increases its expenditure or reduces the tax rate in the US, then in the short run, will increase the income of the consumers and hence, increases their consumption in the US. An increase in consumption implies that imports will also increase, which will put depreciation pressure on the US exchange rate against Mexico's currency.

An increase in imports from Mexico will increase the income of Mexico residents as their exports will increase, which will increase their domestic consumption, and hence, increases production and reduces unemployment in the economy. An increase in net-exports will shift the IS curve to the right, which will increase the interest rate of the economy, which will, in turn, reduce the investment in the economy, as there is an inverse relationship between investment and interest rate.

Case 2: Contractionary Fiscal Policy in the US

In contractionary fiscal policy, when the government either reduces its expenditure or increases the tax rate in the US, then in the short run, it will decrease the income of the consumers and hence, reduces their consumption in the US. A fall in consumption implies that imports will fall, which will put an appreciation pressure on the US exchange rate against Mexico's currency.

A fall in imports from Mexico will reduce the income of Mexico residents as their exports will fall, which will reduce their domestic consumption, and hence, decreases production and increases unemployment in the economy. A fall in net-exports will shift the IS curve to the left, which will lead to a fall in the interest rate of the economy, which will, in turn, increases the investment in the economy.