Suppose the government of the United States has instituted an expansionary fiscal policy to boost aggregate output. The United States has a floating exchange-rate regime and there is a high degree of capital mobility.a. If the exchange-rate value of the dollar remains steady, what are the effects of the expansionary fiscal policy on the U.S. national product and income? What is the effect on the U.S. unemployment rate? Explain.b. Following the fiscal expansion, what is the likely pressure on the exchange-rate value of the dollar? Explain.c. What are the implications of the change in the exchange-rate value of the pound for U.S. national product and unemployment? Does the change in the exchange rate tend to reinforce or counteract the expansionary thrust of U.S. fiscal policy? Explain.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE:

a. If the exchange-rate value of the dollar remains steady, fiscal expansion increases aggregate demand, so real product increases. The unemployment rate in the United States tends to decrease as domestic production increases. Fiscal expansion also increases domestic interest rates as the government borrows more.

b. There are two opposing tendencies for the exchange-rate value of the dollar. The increase in income raises imports and worsens the current account balance. The interest rate rise tends to draw capital from abroad into the domestic economy. The improvement in the financial account tends to strengthen the dollar, but the deterioration in the current account tends to weaken it. If capital is highly mobile internationally, the capital inflow effect is larger and the dollar appreciates.

c. When the country's currency appreciates, the country loses price competitiveness in international markets. The country's exports decline and its imports increase. The deterioration of the country's current account balance reduces the expansionary effects of the fiscal change on the country's domestic product. This implies that the expansionary effects of the fiscal change on the country's domestic product are counteracted by the appreciation of its currency.