International Finance Theory and Policy
by Steven M. Suranovic

Finance 70

Finance 70

Finance Questions 70 2-5

1A. The US currently maintains a floating exchange rate. In the past few years its government budget deficit has risen to a very high level. At the same time its trade deficit has also become much larger. Suppose the government reduces government spending to reduce the budget deficit. Assume the US economy can be described with an AA-DD model. In the adjustment to the new equilibrium the following variables will be affected in the order listed. Indicate whether each variable rises (+) or falls (-) during the adjustment process.

G - Government spending  
AD - Aggregate demand  
Y$ - Aggregate Supply  
L(i$,Y$) - Real Money Demand  
i$ - Interest rates  
RoR$ - US Rate of Return  
E$/£ - Exchange Rate  
RoR£ - Foreign Rate of Return  
q$/£ - Real Exchange Rate  
CAD - Current account demand  
AD - Aggregate Demand  

B. Once the final short-run equilibrium is reached, indicate the effect of the decrease in government spending on the following variables. For the price level only, indicate the direction of change in the long run.

US government budget deficit  
US dollar value  
US current account deficit  
US price level (long-run)  


International Finance Theory and Policy - Chapter 70: Last Updated on 1/6/08