Curiosity 14.1: What Is the Full-Employment Budget?

(currency) and in return provides dollars. The most important implication of this process is that the domestic money supply increases by the increase in dollars times the money multiplier. The increase in the money supply in turn affects economic activity as described in chapters 8, 9, and 10.
When there is a balance of payments deficit, the opposite occurs. We are supplying more dollars on the foreign exchange market (seeking foreign currency to take vacations abroad, for example) than there is foreign demand for dollars, so those of us unable to obtain foreign currency from foreigners go to the Fed to buy foreign exchange at the fixed rate. To buy the foreign currency we give the Fed dollars, removing them from public circulation and thereby decreasing the domestic money supply.
To summarize, if the economy has a fixed exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the money supply to change, in turn affecting economic activity.
Armed with these two general results that international imbalance causes exchange-rate changes under a flexible exchange rate system and money-supply changes under a fixed exchange rate system we can examine how monetary and fiscal policy are affected by repercussions from the international sector. To maintain simplicity, all analysis ignores price-level changes and inflation. Incorporating them would not change the general results, only the breakdown of nominal income changes into real changes and price changes.
6.3
Fiscal Policy Under Flexible Exchange Rates
An increase in government spending leads to an increase in income and an accompanying increase in the interest rate, causing some crowding out. The increase in income increases imports, creating a balance of payments deficit, but the increase in the interest rate causes capital inflows, creating a balance of payments surplus. Which will dominate? The consensus among economists on this empirical question is that the latter will outweigh the former. Because of the high mobility of international capital, a slight increase in our interest rate causes a substantial capital inflow, outweighing the impact on the balance of payments of the accompanying rise in imports.
Once this empirical question is settled, it is easy to see how international forces modify the impact of fiscal policy. Under a flexible exchange rate system, the balance of payments surplus created by a stimulating dose of fiscal policy causes the exchange rate to appreciate. This increase decreases exports directly decreasing demand for domestically produced goods and services. It also in creases imports, thereby decreasing demand for domestically produced goods and services that compete against imports. The decrease in aggregate demand for domestically produced goods and services partially offsets the impact on the economy of the stimulating dose of fiscal policy, decreasing the strength of fiscal policy in affecting the income level. All this is summarized in figure 16.1, where the terminology such as "B of P" stands for "balance of payments" and "agg D for g & s'' stands for "aggregate demand for domestically produced goods and services" should be obvious.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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