Answer to Question #283869 in Macroeconomics for Aisha

Question

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 long run assuminh that ricardian equivalence holds

Answer 1

Ricardian equivalence holds that the government can regulate the economy by spending current and future taxes. This implies that an equivalent impact is created in the economy when the government spends money raised from current or future taxes rather than external funding such as debt finance. Trade deficits can be eliminated by increasing government spending instead of reducing it. Furthermore, in Ricardian equivalence theory, government spending is limited to taxes and not debts. Consumers are keen to avoid supporting ideas that will lead to higher future taxes. Therefore, reducing government spending will not eliminate the trade deficit in the economy.