Chapter 34, Problem 1.2P

Subpart (a):

To determine

To show the effect of each event on the current account balance and the exchange rate.

Explanation of Solution

The US government cutting tax rate is an expansionary fiscal policy. When the exchange rates are fixed, an expansionary fiscal policy leads to an increase in the income. This would lead to a rise in the demand for imports and as a result, the current account balance would decrease. This is because the current account shows the difference between the exports and the imports. When the exchange rate floats, the increase in demand for imports may lead to an increase in the supply of dollar in the foreign exchange and as a result, the dollar may depreciate. Thus, under floating rates, though the current account balance would decrease, the impact may be partially reduced if the dollar depreciates.

Economics Concept Introduction

Concept Introduction:

Current account: The current account is the entry of all the transactions of a country's net export, net income on investment, and net transfers as a part of the balance of payment.

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Fixed exchange rate: It is the system of exchange where the exchange rate will be fixed and pre-determined by the central authority. It will be free from the demand and supply of currency in the exchange market.

Floating exchange rate: The floating exchange rate system is a system in which the exchange rate is determined at the equilibrium of the supply and demand for the currency. It will thus change the exchange rate according to the changes in the demand and supply.

Subpart (b):

To determine

To show the effect of each event on the current account balance and the exchange rate.

Explanation of Solution

When the fixed exchange rates prevail, the inflation level in US makes the products less attractive and expensive. This will lead to an increase in the imports and decrease in the exports resulting in a decrease in the current account balance. When the exchange rate floats, inflation would lead to depreciation in the dollar and the current account remains unaffected.

Economics Concept Introduction

Concept Introduction:

Depreciation of currency: It is the process of decreasing the value of a home currency with regard to another foreign currency in the currency exchange market.

Fixed exchange rate: It is the system of exchange where the exchange rate will be fixed and pre-determined by the central authority. It will be free from the demand and supply of currency in the exchange market.

Floating exchange rate: The floating exchange rate system is a system in which the exchange rate is determined at the equilibrium of the supply and demand for the currency. It will thus change the exchange rate according to the changes in the demand and supply.

Subpart (c):

To determine

To show the effect of each event on the current account balance and the exchange rate.

Explanation of Solution

When the US adopts an expansionary monetary policy, the interest rates falls and this makes the US financial securities less attractive. This would reduce the demand for dollar and the supply of dollar increases. This would lead to an increase in the income in US and as a result, the demand for foreign products increases, leading to an increase in demand for imports. When the fixed exchange rates exist, this results in decrease in the current account balance. When the exchange rate floats, the increase in supply of dollar would lead to depreciation in dollar and the increase in imports makes the impact on current account balance uncertain.

Economics Concept Introduction

Concept Introduction:

Appreciation of currency: It is the process of increasing the value of a home currency with regard to another foreign currency in the currency exchange market.

Depreciation of currency: It is the process of decreasing the value of a home currency with regard to another foreign currency in the currency exchange market.

Fixed exchange rate: It is the system of exchange where the exchange rate will be fixed and pre-determined by the central authority. It will be free from the demand and supply of currency in the exchange market.

Floating exchange rate: The floating exchange rate system is a system in which the exchange rate is determined at the equilibrium of the supply and demand for the currency. It will thus change the exchange rate according to the changes in the demand and supply.

Subpart (d):

To determine

To show the effect of each event on the current account balance and the exchange rate.

Explanation of Solution

When the consumers favor the domestically produced goods, the demand for imports decreases and this lead to a decrease in the demand for foreign currency. When the exchange rate is fixed, this would lead to an increase in the current account balance and when the exchange rate floats, this would lead to an appreciation of dollar. However, the impact on current account balance remains uncertain.

Economics Concept Introduction

Concept Introduction:

Appreciation of currency: It is the process of increasing the value of a home currency with regard to another foreign currency in the currency exchange market.

Fixed exchange rate: It is the system of exchange where the exchange rate will be fixed and pre-determined by the central authority. It will be free from the demand and supply of currency in the exchange market.

Floating exchange rate: The floating exchange rate system is a system in which the exchange rate is determined at the equilibrium of the supply and demand for the currency. It will thus change the exchange rate according to the changes in the demand and supply.