Answer to Question #100062 in Macroeconomics for Tiffany

Question

c. Many people believe trade deficits are a serious problem and need to be eliminated.

(i) Explain the three actions the Fed could take to reduce the trade deficit in the U.S., and explain carefully how these actions would result in a reduced trade deficit.

(ii) What effect would these three actions from part I of the question have on GDP? Describe the effects on each of the components of aggregate demand. Include an AD/AS graphical analysis of your answer.

Answer 1

i.(a) Tax capital inflows. To reduce the borrowing rate of the US, a tax on capital inflows that rises with size of the inflow could reduce excessive borrowing for consumption and help close the government imbalance.

(b) Consume less and save more. If the US government or households reduce consumption import will drop and less borrowing from abroad will be needed to pay for consumption.

(c) Depreciate the exchange rate. Trade deficit reversals are typically driven by significant real exchange rate depreciation.

ii.(a) High taxes will result in lower GDP in a country economy. The aggregate demand will therefore increase the aggregate supply decreases.

(b) This result in higher GDP in a country. The aggregate demand will decrease while the aggregate supply increase.

(c) This result in low GDP in a country. The aggregate demand will increase and the aggregate supply decreases.