ch19 - CHAPTER 19 INTERNATIONAL ADJUSTMENT AND...

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CHAPTER 19 INTERNATIONAL ADJUSTMENT AND INTERDEPENDENCE Solutions to the Problems in the Textbook : Conceptual Problems: 1.a. A loss of export markets leads not only to an external deficit but also to a decrease in the level of output. Since a policy dilemma between an external and an internal balance exists, a combination of expenditure-switching and expenditure-raising policies is required. The levying of tariffs helps to achieve an external balance, while an increase in government spending helps to achieve an internal balance. 1.b. A reduction in saving and an increase in the demand for domestic goods will lead to an increase in national income. As a result, imports will increase, leading to a balance of payments deficit. This is not a dilemma situation and an expenditure-reducing policy (a cut in spending) will remedy the situation. 1.c. An increase in government spending will lead to an increase in national income and the level of imports. This will cause a balance of payments deficit. This is not a dilemma situation and an expenditure-reducing policy (a cut in spending) will suffice to reestablish an internal and external balance. 1.d. A shift in the demand from imports to domestic goods will increase output and lead to a trade surplus. This is a dilemma situation and a combination of expenditure-switching and expenditure- reducing policies should be employed. Lowering tariffs combined with a cut in government spending will help to achieve an external and internal balance. 1.e. A reduction in imports with a corresponding increase in saving will not affect the level of national income but it will lead to a trade surplus. An appropriate response is a reduction in income taxes combined with lower tariffs. This will help to reduce the trade surplus without affecting national income. 2. Temporary trade imbalances can be easily financed, since the central bank is not likely to run out of foreign currency reserves rapidly. A country that has a temporary payments imbalance may even borrow foreign currency from abroad as long as the level of domestic investment spending is sufficient to increase the level of output, some of which will eventually be exported. A temporary disturbance in trade patterns can come from a change in exchange rates caused by unstable exchange rate expectations. If a country suffers a permanent imbalance, however, the central bank will eventually run out of foreign currency reserves. A permanent imbalance may be caused by a loss in foreign market share. The adjustment can happen through the automatic adjustment process, but that could involve long periods of high unemployment. Therefore domestic policy changes are required to move the economy more rapidly toward balance. 57
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3. The answer to this question is student specific. Government intervention can help smooth out temporary fluctuations in exchange rates. However, this is often problematic since at the time a currency appreciation occurs, the government can never be sure whether a disturbance is transitory and soon likely to reverse itself or more persistent and fundamental in nature. If unstable exchange
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This note was uploaded on 12/18/2010 for the course SOES 2003 taught by Professor Jian during the Fall '10 term at Uni. Southampton.

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ch19 - CHAPTER 19 INTERNATIONAL ADJUSTMENT AND...

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