Suppose a country has been running a significant expansionary fiscal policy for many years. Monetary policy has not been particularly expansionary or contractionary. What can you expect to happen to this country's trade balance? What are the costs and benefits of this trade imbalance? If the country wished to correct for its trade imbalance, what fiscal and monetary policies would you suggest this country pursue now? (This question would be worth 15 marks)
Consider the equation
S + T + M = I + G + X
where the leakages in the economy are savings (S), taxes (T), and imports (M). The injections are investment spending (I), government purchases (G), and exports (X). To make the equation balance, a trade deficit will result when the government borrows. You will see a similar effect using the ISLM model. Expansionary fiscal moves the IS curve outward, increasing Y and r.
Expansionary fiscal policy that increases the budget deficit, therefore, will in turn raise interest rates, attract international funds, drive ...
Effect of fiscal policy on trade imbalance