Explain how expansionary fiscal policy would affect a country's balance of payments and the use of official intervention, given fixed exchange rates and an initial government budget deficit.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Fiscal policy refers to the government using its taxing and spending authority to influence macroeconomic variables. Changes in fiscal policy affect a country's balance of payments through both the current account and the financial account. If the government has a budget deficit, increased government spending or decreased taxes would further increase the deficit. To finance the larger budget deficit, the government would need to borrow more, which would drive interest rates up. Higher interest rates would attract capital inflow as foreign investors attempt to take advantage of higher returns, which would "improve" the country's financial account.

The increased government spending would also increase aggregate demand, real domestic product and real national income. The rise in real production and income would increase the demand for imports, which would "worsen" the current account balance. The increased aggregate demand may also put upward pressure on the price level. If the price level rises, the country would lose international price competitiveness, which would also cause the current account to deteriorate as domestic goods and services become more expensive relative to foreign goods and services. The effect on the country's overall balance of payments depends on the magnitudes of these changes. The magnitude of the effect on the financial account balance will depend on how responsive international financial capital flows are to interest rate changes. If international capital flows are very responsive to interest rate changes (high capital mobility), then the capital inflows will be large, and the official settlements balance will record a surplus. If the capital flows are unresponsive (low capital mobility), then the financial account will improve only slightly, and the overall balance will record a deficit. 

With fixed exchange rates, a deficit or surplus in the official settlements balance would require that the monetary authority officially intervene to defend the currency, which would necessitate a change in the country's money supply. In the case of a settlements surplus, the central bank would sell the domestic currency and buy foreign currency. In the case of a settlements deficit, the central bank would buy the domestic currency and sell foreign currency. Without sterilization, these changes in the money supply would further impact domestic production and interest rates.