Answer to Question #277806 in Macroeconomics for Bushkid

Question

An open economy with a chronic deficit in the current account as well as in the governments budget. To address the problem the government proposes to cut spending and curtail all public purchases from abroad.

Explain why the government concerned.       (2 mks)

Describe effects of the proposed policy on an economy where there is no capital mobility and there is a fixed exchange rate policy.       (8 mks)

Answer 1

$Solution$

A)The government is trying to avoid occurrence of or increase in inflation by cutting down on government expenditure and by prohibition purchase from abroad. The measure can be said to be contractionary. This will also help reduce budget deficits

B) The policy reduces will reduce the economy's money supply. A drop in the money supply is accompanied by a corresponding decrease in nominal output, also known as GDP (GDP). Furthermore, a reduction in the money supply will result in a reduction in consumer expenditure. The aggregate demand curve will move to the left as a result of this decline. Because there is less capital available in the economy, the drop in money supply lowers price levels and actual output.

The policy reduces GDP while keeping interest rates steady and the exchange rate fixed. Both the trade balance and unemployment are increasing.

A competitive devaluation reduces the value of the currency and raises GNP. Unemployment decreases, interest rates remain unchanged, and the trade deficit narrows.

The reserve currency country's monetary growth causes the domestic country to run a balance of payments surplus in order to keep its fixed exchange rate.

As a result domestic interest rates fall to keep pace with declining foreign interest rates. Domestic GNP, as well as unemployment and the trade balance, remain unchanged.

When a country experiences recurrent balance of payments deficits while seeking to preserve its fixed exchange rate and is ready to deplete its reserves, a currency crisis occurs.