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7 18
Balance of Payments I: Output,
Exchange Rates, and Macroeconomic
Policies in the Short Run
1. In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan
were both concerned about a sluggish U.S. economy. They also were concerned about
the large U.S. current account deficit. To help stimulate the economy, President Bush
proposed a tax cut, whereas the Fed had been increasing U.S. money supply. Compare
the effects of these two policies in terms of their implications for the current account.
If policy makers are concerned about the current account deficit, discuss whether
stimulatory fiscal policy or monetary policy makes more sense in this case. Then, re-
consider similar issues for 2009–2010, when the economy was in a deep slump, the
Fed had taken interest rates to zero, and the Obama administration was arguing for
larger fiscal stimulus.
Answer: From the model, we know that fiscal expansion leads to crowding out of
investment and external demand because it leads to an appreciation in the home cur-
rency. In contrast, a monetary expansion leads to a decrease in the interest rate and a
depreciation in the currency, causing an improvement in the current account. There-
fore, if policy makers are concerned about reducing the current account deficit and
want to expand output, they should use monetary policy. These changes are summa-
rized in the following figures.
S-59
S-60 Solutions ■ Chapter 7(18) Output, Exchange Rates, and Macroeconomic Policies
Fiscal expansion
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