Assignment

Consider a large open economy with a flexible exchange rate and free capital flows. Suppose the economy is enjoying full employment, a large budget deficit, a large trade deficit, and a strong currency.

A) Analyze what specific monetary and/or fiscal policies would be required to reduce the budget and trade deficits, while maintaining full employment at the same time.

B) Suppose the newly elected government decides to adopt expansionary fiscal policies (income tax cut plus government spending increase) and contractionary monetary policies, while maintaining full employment. Analyze the short-run impact of this policy mix on the economy's interest rate, exchange rate, fiscal deficit, and trade deficit.