Question

Suppose the foreign government increases its Lump Sum Taxes. Using appropriate diagrams for the foreign exchange markets of "e" and "x" (1 diagram for each market) explain what happens to the value of the dollar (and why) from this fiscal policy change.

Answer 1

Suppose foreign government increases its Lump Sum Taxes. Then, in the goods market for foreign, the aggregate demand would shift to the left and this would reduce price level and interest rate along with the GDP. Some relief is provided as price of foreign currency is reduced and so currency depreciates. This implies net exports are increased. Now in home country this implies our exports will fall as our currency is relatively expensive and appreciated. Our imports will rise and this will result in worsening the trade deficit. This suggests that home economy faces a reduction in aggregate expenditure as well, shifting the AD to the left.

This is goods market equilibrium where AD shifts left

This is forex market where fall in foreign interest rate increases net capital inflow and appreciating dollar