1.) A small open economy with a floating exchange rate is in recession with balanced trade....

1.) A small open economy with a floating exchange rate is in recession with balanced trade. If policymakers want to reach full employment while maintaining balanced trade, what combination of monetary and fiscal policy should they choose? Use a graph and explain the effects of each policy.

Expert Solution

Ans. A combination of expansionary fiscal and monetary policy will increase the output level to full employment level while keeping trade balanced.

Explanation,

An expansionary fiscal policy will increase the government spending increasing the transaction demand for money increasing the interest rate at given level of money supply. This increase in interest rate reduces planned investment spending and also, increases net capital inflow appreciating the domestic currency which makes exports expensive but imports cheaper. Thus, decreasing demand for exports and increasing the demand for imports. This will worsen the trade balance leading to partially offsetting the increase in aggregate demand due to fiscal expansion. So, the new aggregate demand curve, AD', lies to the right of initial aggregate demand curve AD. This increases the price level to P' from P and output level from Y to Y' which is still less than the full employment level of output.
Thus, to bring the economy back to balanced trade condition and full employment level of output, there will be a use of monetary expansion which increases money supply causing interest rate to decrease at given money demand inducing investment and decreasing net capital inflow leading to depreciation of domestic currency. This makes exports cheaper but imports expensive. Thus, demand for exports increases but that of imports decreases increasing the net exports from home country. This brings back the trade to balance. Due to increase in investment and net exports, aggregate demand for goods and services increases shifting aggregate demand curve further to right from AD' to AD". This increases the price level further to P" and increases the output level from Y' to full employment level Y".

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Rahul Sunny answered 2 years ago

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