Country A and B are small open economies. Their economies depend on each other heavily for trade, but their respective governments don't always work together when setting economic policy. Assume (for simplicity) that these countries only trade with each other. Country A decides to decrease domestic taxes to balance its budget.
1) How does country A's policy, assuming they have a floating exchange rate, immediately impact trade between the two countries? Explain answer with graph and two sentences.
2) Now assume Country B pegs their currency (fixed exchanged rate) to Country A's currency. How should Country B's central bank respond to Country A's policy to control short run output? How does Country B's new policy impact trade relative to BEFORE Country A changed their tax policy? Explain answer with graph and two sentences.
3) Suppose Country A's central bank contracted money supply to combat inflation simultaneously with their new tax policy (explained before part 1). With this new information, would your answer in part 2 change for Country B's optimal central bank policy to fix their exchange rate? Explain your logic.
1) When Country A decreases domestic taxes, assuming they have a floating exchange rate, it immediately impacts trade between the two countries. The decrease in domestic taxes would increase the after-tax returns on domestic investments, attracting more capital flows into country A. This would result in an appreciation of country A's currency, causing its exports to become relatively more expensive for Country B. Conversely, imports from Country B would become relatively cheaper for Country A, leading to a decrease in Country A's exports to Country B and an increase in Country A's imports from Country B, as shown in the graph.
[Graph: Country A decreases domestic taxes, floating exchange rate]
Axes:
- X-axis: Quantity of Exports/Imports
- Y-axis: Price of Exports/Imports
Before the tax decrease:
- Export curve: downward sloping (Representing Country A’s exports to Country B)
- Import curve: upward sloping (Representing Country A’s imports from Country B)
After the tax decrease:
- Export curve: shifts down and to the left (due to relative appreciation of Country A's currency)
- Import curve: shifts up and to the right (due to relative depreciation of Country B's currency)
Explanation of the graph: The shift in the export curve indicates a decrease in exports from Country A to Country B, while the shift in the import curve indicates an increase in imports from Country B to Country A due to the changed relative prices.
2) If Country B pegs its currency to Country A's currency and Country A decreases its domestic taxes, Country B's central bank should respond by implementing expansionary monetary policy to control short-run output. The central bank of Country B would need to intervene in the foreign exchange market by buying Country A's currency, increasing the money supply in Country B, and depreciating its currency. This would help to offset the appreciation pressure on Country A's currency caused by the tax decrease, allowing Country B to maintain its export competitiveness. Additionally, Country B's new policy would likely result in an increase in its exports to country A, as the depreciation of its currency makes its exports relatively cheaper for Country A, while its imports from Country A would become relatively more expensive.
[Graph: Country B pegs currency to Country A, fixed exchange rate]
Axes:
- X-axis: Quantity of Exports/Imports
- Y-axis: Price of Exports/Imports
Before pegging and tax decrease:
- Export curve: downward sloping (Representing Country B’s exports to Country A)
- Import curve: upward sloping (Representing Country B’s imports from Country A)
After pegging and tax decrease:
- Export curve: shifts down and to the left (due to relative appreciation of Country A's currency and Country B's depreciation)
- Import curve: shifts up and to the right (due to relative depreciation of Country B's currency and Country A's appreciation)
Explanation of the graph: The shift in the export curve indicates a decrease in exports from Country B to Country A, while the shift in the import curve indicates an increase in imports from Country A to Country B due to the changed relative prices. However, the depreciation of Country B's currency helps to offset the appreciation pressure on Country A's currency, allowing Country B to maintain its export competitiveness.
3) If Country A's central bank contracted the money supply to combat inflation simultaneously with the tax decrease, Country B's optimal central bank policy to fix their exchange rate could potentially change. If the contractionary monetary policy in Country A leads to a decrease in Country A's imports from Country B, it may reduce the demand for Country B's currency and put downward pressure on its value. In such a scenario, Country B's central bank might need to intervene in the foreign exchange market by selling its own currency, reducing the money supply in Country B, and appreciating its currency to maintain the fixed exchange rate. However, the precise optimal central bank policy would depend on various factors like the magnitude of the contractionary monetary policy and its impact on the trade balance between the two countries.
1) Assuming that Country A has a floating exchange rate, decreasing domestic taxes would have an immediate impact on trade between the two countries. When Country A decreases its domestic taxes, it leads to an increase in disposable income for its citizens, which can stimulate domestic consumption and lead to a higher demand for imports from Country B. This increased demand for imports will cause Country A's currency to depreciate relative to Country B's currency. The graph would show the demand for Country B's currency increasing, shifting the demand curve to the right, causing the exchange rate to move from E1 to E2, resulting in a depreciation of Country A's currency.
2) If Country B pegs its currency to Country A's currency (fixed exchange rate), the central bank of Country B should respond to Country A's policy of decreasing taxes by adjusting its monetary policy to maintain the fixed exchange rate. To control short-run output, Country B's central bank should decrease interest rates or increase money supply to stimulate domestic investment and consumption. This expansionary monetary policy would shift the aggregate demand curve to the right, increasing output in Country B. The graph would show a rightward shift in the aggregate demand curve, causing output to increase from Y1 to Y2, while the exchange rate remains fixed.
Country B's new policy would impact trade relative to before Country A changed its tax policy by potentially increasing the trade imbalance between the two countries. With Country B's expansionary monetary policy, the increased output and domestic consumption may lead to higher demand for imports from Country A. However, if Country B's export industries are not as responsive, it could result in a larger trade deficit for Country B relative to the situation before the policy change.
3) If Country A's central bank contracts the money supply to combat inflation simultaneously with its new tax policy, the optimal central bank policy for Country B to fix its exchange rate might change. In this scenario, if Country A's central bank is actively reducing the money supply, it could lead to a decrease in aggregate demand and output in both countries. To maintain the fixed exchange rate, Country B's central bank might need to adjust its monetary policy to stimulate the economy and offset the contractionary effects from Country A's policies. It could do this by increasing money supply or decreasing interest rates. The logic behind this is that if Country B's central bank does not respond to the contractionary policies in Country A, it may risk a mismatch between the fixed exchange rate and the economic fundamentals, potentially leading to economic imbalances and instability.