Question

14. Consider a 2-country (US and UK) model in which exchange rates are fixed, and assume that the US has a BOP deficit. (a) What should the US do if the deficit is expected to be temporary? What are the possible drawbacks of this policy? (b) Evaluate the policy measures that the US can adopt to eliminate the deficit.

Answer 1

(a) If the trade deficit is temporary then the US can maintain its currenct exchange rate until the excess of imports over exports in the balance of trade takes care of itself. This will all depend on the relative elasticities of demand of exports and imports as per teh Marshall Lerner condition. The exchange rate will thus not change in such a situation, but this may cause a worsening of the BOP over time if the demand for foreign goods rise.

(b) The US can use several measures to eliminate the deficit. Firstly it can devalue its home currency which will increase the demand for exports and reduce import demand at home and so the balance of trade improves. Secondly, the US can also reduce interest rates as part of a loose monetary policy and so this reduces the demand for investment in the US and so depreciates the home countrys currency and so improves the balance of payments.