Question

What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war? Does your answer depend on whether this is a local war or a world war?

Answer 1

There will be a negative impact on the trade balance and the real exchange rate of a small open economy when government purchases increase during a war, here the war is related to the local war not the world war.

When the government starts purchasing then it means that the government wants to increase the money supply in the economy and this will happen and there is a negative impact on the trade balances or in other words the trade balance issues the deficit in the economy.

When there is a rise in the import and fall in the export then the situation of the balance of trade deficit will occur in the economy and for the long run, it is not a good policy.

The real exchange rate is also affected when there is a deficit in the balance of trade.