Question

The Republican Congress is currently seeking to pass a permanent fiscal expansion. What are short and long run effects on US output and exchange rate?

Answer 1

Short run and long run effect on output:

In short run, increase in government spending through fiscal expansion would cause rise in demand and if economy operates below the full employment, then there would be rise in the output and employments.

In long run, when government debt rises, it would be compelled to reduce expenditure or raise taxes. it would have adverse impacts on economic system. Further, even if government continue to spend at similar rate, it would cause only inflation in long run.

Exchange Rate:

Rise in fiscal deficit or government expenditure will increase demand for domestic goods and it will spur up inflation rate. Rise in inflation rate will cause fall in export earning. Now due to fall in export competitiveness, depreciation of home currency shall occur in international market.

Excessive demand if cured through the fall in expenditure and rise in taxes, will lead to appreciation of domestic currency in long run. Further, Central bank of country tends to increase interest rate if inflation is high. Then there shall be more inflow of foreign capital which would lead to appreciation of currency.