Question

Argentina’s economy has been experiencing high inflation and instability. To control inflation, the central bank had tried to make importable and exportable goods cheaper inside the country by selling its dollar reserves at low prices in domestic markets, thus raising the real exchange rate of the Argentinian peso against the US dollar. However, as a result of this policy, the central bank lost most of its reserves and in May 2020, Argentina defaulted on its foreign debt and lost its access to international capital markets. Now, the government and central bank want to restore the country’s creditworthiness. To this end, they need to control inflation and stabilize the economy by reducing GDP, while increasing the country’s net exports. Which combination of the following short-term policies can definitely yield a lower GDP and higher net exports?

a. Increase money supply and keep government expenditure unchanged.

b. Reduce government expenditure and keep money supply unchanged.

c. Increase both money supply and government expenditure.

d. Reduce both money supply and government expenditure.

Answer 1

If the government expenditure is reduced while keeping the money supply unchanged, this will lead to a decrease in the rate of interest.

A decrease in the interest rate leads to an increase in net capital outflow. Increase in net capital outflow leads to the depreciation of the Domestic Currency. This will make the Exports cheaper. Hence, the net Exports will increase. Since, the Government expenditure reduced, the GDP would also Decrease.

Hence, reduced Government Expenditure and unchanged money supply yield a lower GDP and higher net Exports.

Therefore, option b is correct.