Question

3. Suppose a country's output is above the policy makers' desired level of

output and is experiencing a trade deficit. Assume that the policy makers'

goals are to achieve the desired level of output (i.e., natural level of output)

and balanced trade. Suppose we do not consider the impact of expectations,

answer the following questions. (Hint: using the ZZ and NX curves)

.

a) Is it possible to use fiscal policy to achieve these two goals

simultaneously? What kind of fiscal policy you should use. Explain.

.

b) If a fiscal policy cannot achieve the two goals simultaneously, what

type of exchange rate and fiscal policy mix can be used? Discuss.

.

c) If an exchange rate policy is used, which curve will shift? How does

this affect the fiscal policy in part a)?

Answer 1

The case given discusses inflationary gap in which economy is producing more that its potential. It can adapt contractionary fiscal policy. In this policy taxes are raised and govt. spending is cut down. As shown in fig. below, country currently is producing at Ye and actual potential is Yf. Aggregate demand has shifted right from AD1 to AD2 and price levels have gone up from Pf to Ple.

a) Is it possible to use fiscal policy to achieve these two goals

simultaneously? What kind of fiscal policy you should use. Explain.

Contractionary fiscal policy(raised taxes and reduced spending) shifts aggregate demand AD2 back to AD1. As aggregate demand goes down, people will buy less from imported goods and balance of trade deficit can be corrected.

b) If a fiscal policy cannot achieve the two goals simultaneously, what type of exchange rate and fiscal policy mix can be used? Discuss.

Revaluation of domestic currency can be made. It will make domestic currency expensive and exports will decrease. People will be left with low income and hence aggregate demand will shift to left. Revaluation should be supported by contractionary fiscal policy as discussed above. .

c) If an exchange rate policy is used, which curve will shift? How does this affect the fiscal policy in part a)?

Revaluation will make domestic currency expensive. Export competitiveness will go down. Peoples income coming from exports will go down and they will spend less in an economy. Aggregate demand will shift to left from AD2 to AD1 and price levels will come down and real GDP potential at Yf will be achieved.