Question

Assume that there are two countries: home and foreign. Home and foreign levels of production are currently equal to full employment and the exchange rate is flexible. Then there is a permanent expansion in the level of home’s government purchases. What are the effects abroad on income, prices, and the exchange rate?

Answer 1

Let us take an example of two countries India ( home country ) and U.S.( foreign country). Indian economy and U.S. economy currently going at full employment equilibrium. Both nations following flexible exchange rate. Flexible exchange rate is a type of exchange rate that is determined by market forces supply and demand.

Then there is permanent expansion in the level of Indian government purchase.That means imports from U.S to India is increasing. With constant exports increase in imports results trade balance deficit in Indian economy. Demand for dollar will be high than supply of dollar due to higher imports. Supply of rupees will be higher than demand for rupees. It leads to depreciation of rupees in terms of dollar.That means exchange rate will rise .

1. Income: Due to higher imports to India by U.S results rise in their national income. Because U.S. exports to India is increasing. Thus ,level of production in U.S. will increase. Thereby it increases, employment level and income level in U.S. economy . 2. Prices. Due to higher exports of U.S., price level will be higher in U.S. economy. Because higher income level increase consumption and investment in the economy. Hence it will increase aggregate demand for good and services in U.S. economy. Increase in aggregate demand leads to rise in general price level in U.S. economy.   

3.Exchange rate: India is importing higher amount of good and services form U.S. So India need higher amount of dollar to purchase U.S. goods and services. It increases the demand for dollar in terms of rupee. Higher demand for dollar leads to appreciation of dollar in terms of rupee. that means exchange rat e of U.S. falls as compared to India. Value of dollar in terms of rupee rises.