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 ) According to the question, we have two policy goals:-

   ( I ) To increase GDP.

   ( II ) To ensure that the trade balance doesn't worsen, or in other words to ensure imports doesn't increase.

According to the Keynesian macroeconomic theory, an expansionary fiscal and monetray policy leads to an increase in aggregate demand, GDP, and employment level in the economy. The effect of expansionary fiscal policy is more pronounced than an expansionary monetary policy.

As can be seen above, increase in government spending increases aggregate demand from ad0 to ad1, which in turn leads to an increase in real GDP from 3 to 6.

Likewise, an expansionary monetary policy by reducing interest rates, will lead to an increase in investment spending and consequently will lead to an increase in aggregate demand, real GDP in the economy.

To ensure that the trade balance doesn't worsen, the government should adopt policy measures to increase exports and decrease imports. This can be achieved by varied policy measures such as by imposing tariffs on imports as well as using non-tariff trade barriers on imports.

( b ) Due to fall in their exports to the U.S., their aggregate demand will decrease, which will worsen their trade balance as imports for them have risen whereas exports have not, GDP, and price level will decrease as producers will have no incentive to increase output of their goods.