Hi all, Can somebody explain what is Expansive and restrictive fiscal policy and their effects on BOP and Exchange rate?
Expansive fiscal policy in domestic country- the government wants to create jobs, increase aggregate demand, get the economy rolling again. The government will run a budget deficit meaning they will spend more money than they receive through taxation. When that happens they will need to borrow from private savings, etc. (recall crowding out effect). So interest rates will increase as a result What will happen? Foreigners will want to convert their currency for the domestic currency to invest in the higher interest rates. This will increase the financial/capital account. Regarding the current account, an expansive policy will increase aggregate demand (as mentioned above) which will demand more imports and reduce exports because more income will be in the domestic country to buy up foreign stuff. Current account will be negative. Increased supply of domestic currency to buy more foreign crap will result in a depreciation in currency. Overall the effect of investment in the domestic country overtakes the current account deficit and currency should appreciate…