Balance of Payments - Fiscal Policy

CFA Level II Economics
#1

Please explain the following:

Restrictive Monetary/Fiscal Policy

  • Reduce inflation
  • reduce economic activity
  • improve current account

Restrictive Monetary Policy

  • Increase real interest rates
  • improve financial account
  • appreciation in exchange rate

Restrictive Fiscal Policy (reducing gov borrowing) ****this i dont get****

  • Reduce real interest rates
  • worsening for financial account
  • uncertain impacton exchange rate
#2

No one is brave enough to tackle this one? lol

#3

I will give you some comments but not for every inquire I’m afraid.

Restrictive Monetary / Fiscal Policy

  1. Reduces inflation (desinflation, not confuse with deflation) because a restrictive policy reduces money supply (for Monetary policy) and reduces public consumption and investment (for fiscal policy), so less money or a lower Gov spending reduces inflation.

  2. Reduces economy activity because 1) right? Less resources used reduces economic transactions so lower GDP finally.

  3. Improves current account because this account represents how well an economy health is. It is like your debt balance internationally speaking. When an economy has invested more than it initially saved (the nation savings), the economy is financed with international savings. But in a restrictive fiscal or monetary policy the investment is assumed to be in levels lower than before and the savings will continiously approaching investment levels or even pass them, so the current account improves. Remember all this is dynamic in time.

Restrictive Monetary Policy

  1. Real interest rates are inversely related to money supply, so when money supply decreases the interest rates increases. Why? Look money as a good and interest rates is its price. Therefore, what happens when a price of a good increases? The consumption of that good decreases. This relation is exactly the same for money. Money allows you to consume, invest, etc so this activate economy. The central banks reduces money supply to in fact reduce those activities, thats why a restrictive monetary policy reduces money supply to increase the price of the money (interest rates), or they can directly change the prime rate to affect the other market interest rates (from short-term to long-term interest rates)

  2. Can’t answer this atm

  3. Appreciation of the exchange rate means that exchange rate has fallen, but why? Look at the foreign exchange market. Lets say USD / EUR = 1.1165 today, this rate means that you need 1.1165 dollars to buy 1 euro, but what happens when the supply of dollars decreases? There is less dollars moving around, so the people trying to buy dollars get it harder to complete their requires or there is less people trying to buy euros, this appreciates the exchange rate (ER falls).

Restrictive FIscal Policy (reduced gov. borrowing)

  1. When the goverment reduces borrowing it meas that the gov reduces bond emissions, so in effect there are less bonds in the market than it was spected. Fewer bonds in the market increases their prices (from short to long-term bonds) so this makes yields to decrease which are interest rates right? Interest rates have decreased.

  2. Can’t

  3. Unknown effect on exchange rates? In one side you have less public economic activity (less public consumption or investment due the lower public financing capabilities) and in the other you have lower interest rates that increases consumption or investment but all this is not clear so, you will need a quantitative study to know the final effect direction. As we know, the foreign market will fluctuate due this opposite forces but the final effect is unkown.

Any question please ask.

Regards

#4

Thank you for your help!

All the best!