Ch9. Fiscal Policy and International Economics — Government Spending, Exchange Rates & Trade

Fiscal Policy

Fiscal Policy: using government spending
  and taxes to manage aggregate demand

Expansionary Fiscal Policy:
  Increase government spending or cut taxes
  → AD rises → GDP rises → employment rises
  → Used during recessions
  (e.g., CARES Act 2020, ARRA 2009)

Contractionary Fiscal Policy:
  Decrease government spending or raise taxes
  → AD falls → inflation pressured downward
  → Used to cool an overheating economy

The Spending Multiplier

Keynesian Multiplier:
  $1 of government spending → $1/MPS of GDP
  MPS = Marginal Propensity to Save = 1 − MPC

  Example: MPC = 0.8 → MPS = 0.2
  Multiplier = 1 / 0.2 = 5
  $500 billion in spending → $2.5 trillion GDP gain

Tax Multiplier:
  Tax cut of $1 → GDP rises by MPC / MPS
  (e.g., MPC = 0.8 → tax multiplier = 4)
  → Less powerful than spending multiplier
    (households save some of the tax cut)

The Crowding-Out Effect

Crowding Out:
  Government borrows (issues Treasuries) to
  finance spending → interest rates rise
  → Private investment falls
  → Fiscal stimulus partially offset

Mitigating Crowding Out:
  Fed accommodates by keeping rates stable
  (coordinated fiscal + monetary policy)

Exchange Rates

Exchange Rate: the price of one currency
  in terms of another

USD/EUR Quote: 1 EUR = $1.10

Dollar Depreciation (weaker USD):
  → US exports cheaper for foreigners → exports ↑
  → Imports more expensive for Americans → imports ↓
  → Trade balance improves
  (J-Curve: short-run deterioration before improvement)

Dollar Appreciation (stronger USD):
  → Exports more expensive → exports ↓
  → Imports cheaper → imports ↑
  → Trade balance worsens

Exchange Rate Determinants:
  Supply and demand for currencies
  Interest rate differentials (higher rates → stronger
    currency — carry trade)
  Purchasing Power Parity (PPP): currencies adjust
    toward equal purchasing power across countries
  Current account balance
  Speculation and market expectations

Comparative Advantage and Trade

Absolute Advantage: producing a good with
  fewer resources than another country
Comparative Advantage: producing a good at
  a lower opportunity cost than another country

Comparative Advantage Principle (Ricardo):
  Even if one country has absolute advantage
  in everything, both countries gain by each
  specializing in their comparative advantage

Example:
             Cars (hrs)  Wheat (hrs)  Wheat/Car OC
  US              2          1            0.5
  China           4          3            0.75

  US: wheat OC = 0.5 < China's 0.75
    → US has comparative advantage in wheat
  China: car OC = 4/3 < US's 2
    → China has comparative advantage in cars

  US exports wheat; China exports cars
  → Both nations gain

Balance of Payments

Current Account:
  Trade in Goods (merchandise trade balance)
  Trade in Services (tourism, finance, IP)
  Primary Income (wages, dividends received abroad)
  Secondary Income (remittances, foreign aid)

Capital & Financial Account:
  Foreign Direct Investment (FDI)
  Portfolio investment (stocks, bonds)
  Other investment; derivatives

Official Reserve Assets:
  Fed's holdings of foreign currency,
    gold, and IMF special drawing rights

Current Account Surplus:
  Exports > Imports → foreign currency inflows
  → upward pressure on USD (appreciation)

US Runs a Persistent Current Account Deficit:
  Offset by capital account surplus
    (foreigners invest in US Treasuries and equities)

Keynesian Multiplier = 1 / MPS = 1 / (1 − MPC) ★★★★★ : MPC = 0.8 → multiplier = 5. Each dollar of government spending produces $5 of GDP if no crowding out. Memory hook: multiplier = 1 ÷ (1 − MPC)

Comparative Advantage = Lower Opportunity Cost ★★★★★ : Even without absolute advantage, specializing in the good with the lower opportunity cost and trading makes both countries better off. (Ricardo, 1817) Memory hook: comparative advantage = specialize where OC is lowest

Dollar Depreciates → Exports Rise ★★★★☆ : Weaker dollar makes US goods cheaper abroad → exports increase, imports decrease → trade balance improves. Memory hook: USD↓ = exports↑ = trade improves

Practice Questions

Q. In an economy with MPC = 0.75, if the government increases spending by $60 billion, by how much does GDP increase?

Multiplier = 1 / (1 − 0.75) = 1 / 0.25 = 4. GDP increase = $60 billion × 4 =$ 240 billion.

Q. The USD/EUR rate moves from $1.10 to$ 1.25 per euro (the dollar weakens). What are the economic implications?

The dollar has depreciated. US-made goods and services become cheaper for European buyers → US exports rise. European goods become more expensive for Americans → US imports fall. Over time, the US trade balance improves. In the short run, the J-Curve effect may cause the trade balance to worsen before it improves, because existing import/export contracts take time to adjust.