Question

Consider an economy with trade deficit. The policymakers are considering two alternatives to reduce the deficit: fiscal policy and exchange rate policy (changing the exchange rate). Explain how each policy would be implemented. What would be the effects of each type of policy intervention on the output level? Illustrate your answers by the Keynesian cross-net export diagrams.

Answer 1

As per the question :-

Trde Deficite:-

A trade deficit typically occurs when a country does not produce enough goods for its residents. Alternatively, a deficit means that a country’s consumers are wealthy enough to purchase more goods than the country produces. When production cannot meet demand, imports from other nations increase

A trade deficit, also referred to as net exports, is an economic condition that occurs when a country is importing more goods than it is exporting. The deficit equals the value of goods being imported minus the value of goods being exported, and it is given in the currency of the country in question.

A trade deficit is not necessarily detrimental because it often corrects itself over time. An increase in imported goods from other countries decreases the price of consumer goods in the nation as foreign competition increases. a trade deficit may lead to the creation of fewer jobs. If the country is importing more goods from foreign companies, prices will go down, and domestic companies may be unable to produce and compete at the lower prices

The lower prices help to reduce the threat of inflation in the local economy. An increase in imports also increases the variety and options of goods and services available to residents of a country. A fast-growing economy might import more as it expands to allow its residents to consume more than the country can produce. Therefore, a trade deficit could indicate a growing economy.

Fiscal Policy:-

Fiscal Policy is used by the government for government’s tax and expenditure policies in an effort to influence the behavior of the economy. Fiscal policy can promote macroeconomic stability by sustaining aggregate demand and private sector incomes during an economic downturn and by moderating economic activity during periods of strong growth. Stabilisation can also result from discretionary fiscal policy-making, whereby governments actively decide to adjust spending or taxes in response to changes in economic activity. Fiscal policies include government expenditure, taxes and subsidies. Direct impacts on SARD arise from expenditure on such things as agricultural research and extension, and public works in rural areas. Taxes, on the other hand, may be targeted to help regulate resource use, such as resource rent taxes or taxes on polluters.

Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M).

Expansionary fiscal policy has no lasting effect on on the position of the aggregate demand curve
The Central Bank through open market operations in the foreign currency exchange market (purchase of foreign currency) increases the supply of domestic currency and prevents changes in the exchange rate
In a small open economy, expansionary fiscal policy causes domestic interest rate to rise above world interest rate. This appreciates the RER. Thus, the Bank prevents crowding out effect on NX.
The supply of domestic currency by the Central bank causes domestic interest rate to fall and equal world interest rate. Thus, the Bank prevents crowding out effect on investment.
The increase in money supply shifts the AD curve even farther to the right.

Tight Fiscal Policy

This involves decreasing AD.
Therefore the government will cut government spending (G) and/or   increase taxes. Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Loose Fiscal Policy

This involves increasing AD.
Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C)
This will tend to worsen the government budget deficit, and the government will need to increase borrowing.

So the government should choose Fiscal policy to achieve that target.

In the context of the open economy we can expand our understanding of the Keynesian Cross by considering specifically the effect of exports and imports. Increasing exports adds to aggregate demand, whilst increasing imports decreases aggregate demand. So aggregate demand can be best thought of as the demand for domestic goods rather than the domestic demand for goods. That is, aggregate demand in an economy depends on the demand (both at home and abroad) for domestic produced goods, rather than the domestic demand for goods, some of which will be spent on buying imports that counts towards another economy’s aggregate demand.