Question

A small open economy with a flexible exchange rate is in a recession and policymakers wish to promote economic growth through higher trade - Goal: ↑NX to ↑Y.    [20 points]

What policy or mix of policies – monetary, fiscal, trade policy - should be implemented to reach this goal?

Explain carefully the sequence of events that will help NX and Y to grow [Hint: r < or > r*, NCI or NCO, e↑ or e↓; ∆NX].

Answer 1

The economy can achieve the required goal by using monetary policy. The central bank of the country can engage in monetary easing by cutting the policy rate, r. As the rates of interest goes down, the interest earned by capital investors goes down and the investors will start looking for other countries with higher returns for investment. This will lead to net capital outflows as capital goes put of the country. This leads to a decline in the demand for currency fo the country in the world currency markets, and thus the currency value goes down. Thus, the domestic currency depreciates (e goes down) and our goods become more competitive in the world markets. Thus, we get an increase in net exports and output levels.