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PS 3

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6 views7 pages

PS 3

Uploaded by

iosonocetinkaya
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1)In 2001, President George W.

Bush and Federal Reserve Chairman


Alan Greenspan
were both concerned about a sluggish U.S. economy. They also were
concerned about
the large U.S. current account deficit. To help stimulate the economy,
President Bush
proposed a tax cut, whereas the Fed had been increasing U.S. money
supply. Compare
the effects of these two policies in terms of their implications for the
current account.
If policy makers are concerned about the current account deficit, discuss
whether
stimulatory fiscal policy or monetary policy makes more sense in this case.
Then, reconsider
similar issues for 2009–2010, when the economy was in a deep slump, the
Fed had taken interest rates to zero, and the Obama administration was
arguing for
larger fiscal stimulus.
Answers: From the model, we know that fiscal expansion leads to crowding out of
investment and external demand because it leads to an appreciation in the home currency.
In contrast, a monetary expansion leads to a decrease in the interest rate and a
depreciation in the currency, causing an improvement in the current account. Therefore,
if policy makers are concerned about reducing the current account deficit and
want to expand output, they should use monetary policy. These changes are summarized
in the following figure.
The situation in 2009–2010 was very different. The Fed had exhausted its monetary
toolkit. Keeping their interest rate target at zero meant the economy was at the zero
lower bound (in a liquidity trap). Under these circumstances, the job of reviving the
economy falls to fiscal policy. As of mid-December, 2010, a tax bill was being considered
by Congress. If the current version of the bill is passed, there will be some additional
stimulus from the two-percentage-point reduction in the payroll tax for a
year, the two-year extension of the Bush tax cuts, and an extension of unemployment
compensation benefits. However, these are all temporary measures. We should not expect
this bill to have the same punch as permanent changes in taxes. And, because of
the deep recession, the U.S. current account deficit for 2009 was about half its 2005
level. Under these circumstances, the United States (and most other countries) did not
pay much attention to the current account. They were properly concerned with reviving
their domestic economies.
2)Suppose that American firms become more optimistic and decide to increase investment
expenditure today in new factories and office space.
How will this increase in investment affect output, interest rates, and the current
account?
Answer: This is an exogenous increase in investment demand. This leads to an
increase in the demand for goods, shifting the IS curve to the right. This leads to
an increase in output and the interest rate. The increase in the interest rate implies
an appreciation in the Home currency that decreases the current account.
This is illustrated in the following figure.
3)How would a decrease in the money supply of Paraguay (currency unit is the
“guaraní”) affect its own output and its exchange rate with Brazil (currency unit is
the “real”). Do you think this policy in Paraguay might also affect output across the
border in Brazil? Explain.
Answer: A decrease in the real money supply leads to a leftward shift in the LM
curve. This leads to a decrease in Paraguay’s output, an increase in Paraguay’s interest
rates, and an appreciation in the guaraní. This is illustrated in the following figure. This
could affect output in Brazil through the trade balance. First, because Paraguay’s income
is lower, Brazil’s exports could decline. Second, because the real has depreciated
relative to the guaraní, this may make Brazilian exports more attractive to foreigners,
potentially boosting Brazil’s trade balance. The overall effects on Brazil’s trade balance
and its output are ambiguous.At the same time, Brazil’s economy is over 15 times the
size of Paraguay’s. Therefore, the impact of a change in Paraguay’s monetary policy on
Brazil’s economy is likely to be small.
4).

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