EC2102 Tutorial 6 - Fiscal Policy on the Real Exchange Rate in a Small Open Economy
We can now use the model developed over the last number of tutorials to show how changes in economic policy effect the real exchange rate.
Fiscal Policy at Home
We can ask the question what happens the real exchange rate if the government reduces national savings by increasing government purchases or cutting taxes? This is effectively an expansionary fiscal policy implemented by the Small Open Economy. As discussed previously this reduces savings and lowers the S – I curve. This lowering NX. That is the reduction in savings causes a trade deficit. The below interactive figure shows how the equilibrium real exchange rate adjusts to ensure that NX falls when savings are decreased. The change in policy shifts the vertical line S-I to the left, lowering the supply of domestic currency to be invested abroad. This lower supply causes the equilibrium real exchange rate to rise. That is the domestic currency becomes more valuable. Because of the rise in the value of the domestic currency, domestic goods become more expensive relative to foreign goods, which causes exports to fall and imports to rise. The change in exports and the change in imports both act to reduce net exports. This causes a movement in net exports. The impact of a contraction in fiscal policy can also be analysed.
Fiscal Policy at Home
We can ask the question what happens the real exchange rate if the government reduces national savings by increasing government purchases or cutting taxes? This is effectively an expansionary fiscal policy implemented by the Small Open Economy. As discussed previously this reduces savings and lowers the S – I curve. This lowering NX. That is the reduction in savings causes a trade deficit. The below interactive figure shows how the equilibrium real exchange rate adjusts to ensure that NX falls when savings are decreased. The change in policy shifts the vertical line S-I to the left, lowering the supply of domestic currency to be invested abroad. This lower supply causes the equilibrium real exchange rate to rise. That is the domestic currency becomes more valuable. Because of the rise in the value of the domestic currency, domestic goods become more expensive relative to foreign goods, which causes exports to fall and imports to rise. The change in exports and the change in imports both act to reduce net exports. This causes a movement in net exports. The impact of a contraction in fiscal policy can also be analysed.
Fiscal Policy Abroad
We can also ask what happens to the real exchange rate if foreign governments increase government purchases or reduce taxes. This change in fiscal policy reduces world savings and raises the world interest rate. The increase in the world interest rate reduces domestic investment I, which raises S – I and thus NX. That is an increase in the world interest rate causes a trade surplus. This is due to domestic currency becoming less valuable, and domestic goods becoming less expensive relative to foreign goods.
Expansionary fiscal policy abroad reduces world savings and raises the world interest rate. The increase in the world interest rate reduces investment at home, which in turn raises the supply of the domestic currency to be converted into foreign currency. As a result the equilibrium real exchange rate falls. The domestic currency becomes less valuable and domestic goods become less expensive relative to foreign goods.
We can also ask what happens to the real exchange rate if foreign governments increase government purchases or reduce taxes. This change in fiscal policy reduces world savings and raises the world interest rate. The increase in the world interest rate reduces domestic investment I, which raises S – I and thus NX. That is an increase in the world interest rate causes a trade surplus. This is due to domestic currency becoming less valuable, and domestic goods becoming less expensive relative to foreign goods.
Expansionary fiscal policy abroad reduces world savings and raises the world interest rate. The increase in the world interest rate reduces investment at home, which in turn raises the supply of the domestic currency to be converted into foreign currency. As a result the equilibrium real exchange rate falls. The domestic currency becomes less valuable and domestic goods become less expensive relative to foreign goods.
