Question

1. Imagine that you run the central bank in a large open economy with a floating

exchange rate. Your goal is to stabilize income, and you adjust the money supply

accordingly. Under your policy, what happens to the money supply, the interest rate,

the exchange rate, and the trade balance in response to each of the following shocks:

A. The government raises taxes to reduce the budget deficit

B. The government restricts the import of foreign cars

Answer 1

1) when the government increases taxes to reduce the budget deficit, it increases public savings and therefore National savings. The supply of loanable funds curve shift to the right. This decreases the rate of interest and this causes an increase in net capital outflow. Demand for currency decreases and therefore exchange rate depreciates. Trade balance improves because net exports increase. Because of reduction in real GDP, the role of the central bank becomes important and, it uses a monetary expansion to increase the money supply. This causes the aggregate demand to shift to the right and the real GDP is increased once again. In this way the central bank can stabilize the real GDP by increasing money supply

2) this is going to decrease imports and increase net exports so that trade balance is improved initially. For a large economy this will not make any change. as the demand for the currency increases and the currency is appreciated, there is no final change in the trade balance which implies that Net capital outflow and net exports will remain unchanged. There is no need to change money supply.