Solution for International Macroeconomics 3rd Edition Chapter 7, Problem 1

by Robert C. Feenstra, Alan M. Taylor, James Taylor
285 Solutions 11 Chapters 40215 Studied ISBN: 9781429278430 Economics 5 (1)

Chapter 7, Problem 1 : 1. In 2001, President George W. Bush and...

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, reconsider 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.


Step-By-Step Solution

1. 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 currency. 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. Therefore, if policy makers are concerned about reducing the current account deficit and want to expand output, they should use monetary policy. These changes are summarized in the following figures.


Fiscal expansion


Monetary expansion


The situation in 2009–2010 was very different. The Fed had exhausted its monetary toolkit. Keeping their interest rate target at zero meant the economy was at the zero lower bound (in a liquidity trap). Under these circumstances, the job of reviving the economy falls to fiscal policy. In December, 2010, a tax bill was passed by Congress, providing a two-percentage-point reduction in the payroll tax for a year, extending Bush tax cuts and unemployment compensation benefits. However, these are all temporary measures. We should not expect this bill to have the same punch as permanent changes in taxes. And, because of the deep recession, the U.S. current account deficit for 2009 was about half its 2005 level. Under these circumstances, the United States ( and most other countries) did not pay much attention to the current account. They were properly concerned with reviving their domestic economies.




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