Answer to Question #284247 in Macroeconomics for hadiqa

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 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.

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. This policy will make the country continue to lag in terms of aggregate demand, consume less in taxes. In the short run the country will not stimulate aggregate demand due to lack income among the population, there will be high production but the consumption will be low. In the long run, the country will push towards equilibrium where the aggregate supply will equal to aggregate demand. Flexible exchange rate will be affected by the general economic growth through exports against export, domestic prices against international market prices.

The price of goods due to reduction of government spending will reduce since the demand is low, thus pushing economic growth down and also reduce inflation. The aggregate demand will shift to the left while the exchange rate curve will shift to the right.