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27. Some politicians in the US would like to see steps taken towards reducing the country's twin deficit, i.e. a budget and trade deficit. To this end, two famous economists propose two different policies: (i) a fiscal policy focus on decreasing the budget deficit directly, (ii) a monetary policy focus on increasing the real money supply, i.e. a decrease in the price level due to the combined effect of the nominal money supply remaining unchanged and productivity gains in the economy. Explain the market for loanable funds (LF) in an open economy, the market for foreign currency exchange (FCE) and the LF-FCE transmission mechanism that links the LF and FCE markets. Use the corresponding models and the interest rate and exchange rate effects to evaluate the respective effects of the two proposed policies in view of the US politicians' goal of reducing the country's twin deficit and make well-argued policy recommendations.
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