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 an absolute advantage in everything, both countries gain when each specializes in its comparative advantage.

Example — hours needed to produce one unit

	Cars (hrs)	Wheat (hrs)	Opportunity cost of wheat (in cars)
US	2	1	0.5
China	4	3	0.75

US: wheat opportunity cost 0.5 < China’s 0.75 → the US has a comparative advantage in wheat
China: car opportunity cost 4/3 < the US’s 2 → China has a comparative advantage in cars
The US exports wheat and 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)

Key Concept Cards

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.