Answer to Question #279137 in Macroeconomics for likenaw

Question

Suppose that you are the economic advisor to the President of Djibouti. As per

your assessment the country’s exchange rate falls too low. As a result you

recommend Djibouti to reduce its budget deficit in order to raise the exchange

rate.

Use the long-run model of a small open economy (assuming Djibouti as a

Small Open Economy (SEO)) to illustrate graphically the impact of

reducing the government's budget deficit on the exchange rate and the

trade balance. Be sure to label:

i. the axes

ii. the curves

iii. the initial equilibrium values

iv. the direction the curves shift

v. the new long-run equilibrium values.

b. Based on your graphical analysis, explain whether your policy

recommendation will work. Specifically state what happens to the exchange

rate and the trade balance as a result of the government budget deficit

reduction

Answer 1

b. The policy wont work

High budget defict reduces supply making supply curve to shift from supply₀ to supply₁ for loanable funds therefore increasing interest rates in the economy. Net capital decreases as well which leads to high exchange rates. Therefore, when Djibouti reduces its budget deficit, the supply of loanable funds in the country increases which leads to a decline in interest rates. The decline in interest rates increases net capital which consequently leads to decrease in interest rates. The new equilbrium will at e₂ which is slightly lower than the previous exchange rate as oppoosed to the expected increase.