Notes On International Economics

BEA202 International Economics
Question 1
A) Contractionary fiscal policy: combination of higher taxes and/or lower government spending – aims to reduce budget deficit/increase size of surplus.
With the introduction of contractionary fiscal policy, this increase of taxes leads to a decrease in consumer consumption. Consumers have less money to spend so consumption spending will decrease leading to a decrease in demand for goods and services which leads to a decrease in output level. This leads to the shift of IS to IS1 as shown to the right.

i
LM

IS1

IS

Domestic Production

The increase in taxes reduces disposable income and reduces aggregate demand. Australian domestic product and income will fall
(or be lower than they otherwise would be). If national income is lower, spending on imports will be lower, so the Australian current account will improve. The increase in taxes reduces the government budget deficit.
The government borrows less, and Australian interest rates are lower. If international capital flows are responsive to changes in interest differentials, then the lower Australian interest rates lead to capital outflows (or less capital outflows). The Australian financial account declines. The effects of contractionary fiscal policy with floating exchange rates are shown in the flowchart below.

Keynesians argue that fiscal policy can be used to combat expected increases in the rate of inflation. The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand. The government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have.
B) The pressures on the exchange rate value of the dollar depend on which change is larger: the improvement in the current account or the deterioration in the financial account. If the effect on capital flows is larger, than demand for dollars will decrease (relative to the supply of dollars) in the foreign exchange market, so the dollar will depreciate. If the current account change is larger, then the supply of dollars
(relative to the demand) will decrease, so the dollar will appreciate.
A depreciation of the currency leads to an expansion of exports and a contraction of imports. Thus, for any given level of income, a larger amount of net capital outflows, and thus a lower rate of interest, is required to balance to balance of payments. The FE curve thus shifts down (to the right) with currency depreciation to FE1. In an appreciation of the currency leads to greater imports and fewer exports, thus requiring a smaller amount of net capital outflows (or larger net capital inflows) to obtain external balance. A higher interest rate is therefore required at all levels of income, causing the FE curve to shift up to FE2, which is shown in the diagram below.

i

FE2
Appreciation

FE
FE1

Depreciation

Domestic Production

C) The Australian government’s tighter fiscal policy initiative is being reinforced providing it reduces the deficit within the economy. If the exchange rate depreciate and imports become higher and therefore people have higher cost and if this results in higher debt levels then it

does not help reduce national debt.
D) The exchange rate will play an important role for firms who export goods and import raw materials. Essentially
•

When there is a depreciation and the exchange rate goes down, the exports of a country will be cheaper and the imports more expensive. A depreciation of the dollar makes Australian firms more competitive.
The downside of a depreciation is that Australian firms who import raw materials will see an increase in the cost of buying raw materials. For example, if the Australian car company imports engines from Germany to make the car, it will have to pay more to buy the engines. This will reduce its profit

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