In 2005 the US was close to full employment, but many observers and economists w
ID: 1251755 • Letter: I
Question
In 2005 the US was close to full employment, but many observers and economistswere worried about its trade deficit, which was over $700 billion per year. Suppose
macroeconomic policymakers wanted to maintain the level of real GDP in the short
run but change the real exchange rate to reduce the trade deficit. Assuming that the
US is a large open economy, state which specific monetary and/or fiscal policies
would be required to achieve these objectives in the short run? Briefly explain using
the Mundell-Fleming model and appropriate graphs.
Explanation / Answer
In 2005 the US was close to full employment, but many observers and economists
were worried about its trade deficit, which was over $700 billion per year. Suppose
macroeconomic policymakers wanted to maintain the level of real GDP in the short
run but change the real exchange rate to reduce the trade deficit. Assuming that the
US is a large open economy, state which specific monetary and/or fiscal policies
would be required to achieve these objectives in the short run? Briefly explain using
the Mundell-Fleming model and appropriate graphs.
Trade deficits are the result of more going out than comes in.
That means that we spend more than we take in.
Thus our currency is worth more than their currency. To make our currency more desirable - increase demand for our currency by making it cheaper - we must decrease the value of our currency.
This means "decreasing the price of the dollar." How? Inflation.
The Federal Reserve should pursue an expansionary policy; specifically, the Fed should increase the monetary supply in the short and long run to increase the amount of money in circulation and thus devalue the dollar.
Though fiscal policy is less effective in this respect, for maximum effect, the federal government should decrease spending, which decreases domestic demand for dollars and decreases the price of the dollar, limiting the "crowding out" effect and making the dollar more desirable - demandable - to foreigners.
When our dollar is demanded more, more is bought.
When more is bought, our trade deficit is reduced.
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