Assume that the government has a target value, X, for the current account surplus

Question

(a) What is the goal of external balance? (b) Assume that we are dealing with only the short run, what are the values of P and P?? (c) Given fixed P and P , what would happen if E rises? (d) Given P and P , what would happen if T decreases, i.e., an expansionary fiscal policy? (e) Given P and P , what would happen if G increases, i.e., an expansionary fiscal policy? (f) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (g) Assume that the economy is in external balance. What will happen if the government maintains its current account at X, but devaluates the domestic currency? (h) Assume that the economy is at external balance. What will happen if the government raises E? (i) Assume that the economy is at external balance. What will happen if the government lowers E?

Answer 1

(a) The goal of external balance requires the government to manage fiscal policy and the exchange rate so that the following equation is satisfied: CA(EP /P, Y - T) = X.
(b) Constant prices.
(c) An increase in E makes domestic goods cheaper, thus improving the current account.
(d) A fall in T raises output, Y. The resulting increase in output increases disposable income and thus leads to increased home spending on foreign goods, worsening the current account.
(e) Similar to the answer above. A rise in G causes CA to fall by increasing Y.
(f) Positive relationship.
(g) The government raises E; thus, either G should go up or T should go down to maintain the external balance.
(h) An increase in E raises net exports and thus leads to a surplus in the current account higher than the target level of X. This will represent a point above the XX schedule.
(i) A decrease in E reduces net exports and thus leads to a deficit in the current account lower than the target level of X. This will represent a point below the XX schedule.