A. Describe how a contractionary monetary policy impacts a nation\'s internation

Question

A. Describe how a contractionary monetary policy impacts a nation's international trade. Be sure to discuss the value of that nation's currency, the price of goods produced in that nation, and its trade balance. (10 points)

B. Describe the effect of expansionary economic policies on a nation's trade deficit. Be sure to consider both monetary and fiscal policy. (10 points)

C. According to the twin deficits effect, an increase in the government budget deficit will also increase that nation's trade deficit. Explain why this effect is expected to occur. (7 points)

Explanation / Answer

Contractionary monetary policies are used by governments to slow down an economy, majorly if the nation's inflation is high. As a result of contractionary monetary policy, interest rates are increased making it attractive for foreign investors to invest in the country, international value of nation's currency increases (dollar in this case), imports increase, exports decrease resulting in an increase in trade deficit. Also as inflation is decreased the rate at which price of goods increases also slows down.

Expansionary economic policies, both monetary and fiscal are designed to stimulate nation's economy. Fiscal policy increases government spending and reduces taxes while monetary policy decreases interest rates. Money flow in the system increases as a result of both, discourages foreign investment, weakens dollar, decreases imports and increases exports resulting in reducing the trade deficit.

Twin deficit is a scenarion in which a nation has both fiscal as well as current account deficit. Fiscal deficit is excess spending over and above the revenue whereas current account deficit is trade deficit (net of exports and imports) The increase in the government budget deficit is due to lower income (for the government) which is a result of tax cuts, this encourages consumer spending and lower savings, hence the government needs foreign borrowings to fund its deficits resulting in current account deficit.

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