Answer to Question #277067 in Macroeconomics for Kay

Question

Q.2 a) An economy following a flexible exchange rate regime is in its long run equilibrium while suffering from a trade deficit. Would a reduction in government spending be helpful in eliminating the trade deficit? Explain indicating all co-movements both in the short run and the long run (assuming that Ricardian Equivalence holds)? How would this policy affect the trading partner of the home country?

Use the IS-LM-FE and the foreign exchange market diagrams to explain.

b) Using the analysis in part (a), indicate why the central bank of the trading partner may opt for a fixed exchange rate regime. If the exchange rate were to be fixed between the initial and the new

equilibrium values (in domestic economy), what do you think the policy would imply? What effects

would it have on the home economy and the trading partner? Use the foreign exchange market and the FV-Ms diagrams to explain.

Answer 1

(a) Ricardian comparability is an economic theory that states that funding government spending with current or future taxes has the same overall effect on the economy. This means that efforts to boost the economy by expanding debt-financed government spending will fail since consumers and investors are aware that the loan will eventually be repaid through future taxes.

(b) The primary motivation for countries to consider forming a currency board is to implement a visible anti-inflationary policy. With a currency board in existence, the central bank can no longer act as an unrestricted lender of last resort to financially distressed institutions. For the sake of export and commerce, countries favor a fixed exchange rate system. A country can — and will — maintain its exchange rate low by controlling its domestic currency. This contributes to the goods' competitiveness when they are sold.