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Using fiscal policy to address trade imbalances

If a nation is experiencing the inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms, there may be no substantial reason for concern. After all, many low-income nations around the world would welcome direct investment by multinational firms that ties them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private sector investment in an economy.

However, governments should beware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms, but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country’s exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche; a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.

Reducing a nation’s budget deficit will not always be a successful method of reducing its trade deficit, because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession.

Financing higher education

Over the period between 1982 and 2012, the increases in the cost of a college education had far outpaced that of the income of the typical American family. According to the research done by the President Obama’s staff, the cost of education at a four-year public college increased by 257% compared to an increase in family incomes of only 16% over the prior 30 years. The ongoing debate over a balanced budget and proposed cutbacks accentuated the need to increase investment in human capital to grow the economy versus deepening the already significant debt levels of the U.S. government. In the summer of 2013, President Obama presented a plan to make college more affordable that included increasing Pell Grant awards and the number of recipients, caps on interest rates for student loans, and providing education tax credits. In addition, the plan includes an accountability method for institutions of higher education that focuses on completion rates and creates a College Scorecard. Whether or not all these initiatives come to fruition remains to be seen, but they are indicative of creative approaches that government can take to meet its obligation from both a public and fiscal policy perspective.

Key concepts and summary

The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several negative macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level; crowding out private investment in physical capital in a way that slows down economic growth; and creating a dependence on inflows of international portfolio investment which can sometimes turn into outflows of foreign financial investment that can be injurious to a macroeconomy.

Problems

Sketch a diagram of how a budget deficit causes a trade deficit. ( Hint : Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.)

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Sketch a diagram of how sustained budget deficits cause low economic growth.

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Assume that you are employed by the government of Tanzania in 1964, a new nation recently independent from Britain. The Tanzanian parliament has decided that it will spend 10 million shillings on schools, roads, and healthcare for the year. You estimate that the net taxes for the year are eight million shillings. The difference will be financed by selling 10-year government bonds at 12% interest per year. The interest on outstanding bonds must be added to government expenditure each year. Assume that additional taxes are added to finance this increase in government expenditure so the gap between government spending is always two million. If the school, road, and healthcare budget are unchanged, compute the value of the accumulated debt in 10 years.

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References

The White House. “This is why it's time to make college more affordable.” Last modified August 20, 2013. http://www.whitehouse.gov/share/college-affordability.

Rubin, Robert E., Peter R. Orszag, and Allen Sinai. “Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray.” Last modified January 4, 2004. http://www.brookings.edu/~/media/research/files/papers/2004/1/05budgetdeficit%20orszag/20040105.pdf.

Questions & Answers

what is the important of studying economics
Akurugu Reply
economics teaches you how to think not what think
umer
is labour a intermediate good or final good
umer Reply
what is economics
Mahamed Reply
Economic is science, which Studies human behaviour and who they are earn and spend
Ammu
economics is the science which shows how can use scare resources among society
umer
how to derive the equation for the equilibrium level of national income in an open economy with no taxes
loise Reply
what is inflation?
Herry Reply
when price goes up with some shottime
umer
Give me 5 example for Macro economics
Neha Reply
1. Markets 2. Market Failure 3. Competition 4. Price Stability 5. Efficiency
Luyando
please can you explain markets and markets failure ?
Timothy
When we talk about Markets as an example of macroeconomics, we look at demand and supply in labor market.
Luyando
Then for market failures, we focus on market inefficiencies and failures such as the destruction of common goods due to economic systems that provide no incentive for their preservation
Luyando
Who is a discourage worker.?
Timothy
a discourage worker is simply a worker who stop looking for a job because he/she believe no job is available for them..
Joseph
sloping curve normal
Mirasol Reply
A normal sloping curve
Mirasol
State what happen to the aggregate supply curve for beef. The price of beef decrease
Mirasol
i think there is positive relationship between price n supply so as the price decreases the supply curve so decreases and vice versa
Dharani
quantity supply will decrease,less.profit for firms in a perfectly competitive market i guess
Joseph
yaa
Dharani
List two REASONS FOR LOW PRODUCTIVITY IN DEVELOPING COUNTRIES?
KHONAYE Reply
DESCRIBE WHY MARGINALISED GROUPS ARE NORMALLY AFFECTED FIRST DURING A RECESSION.I'M IN GRADE 11
KHONAYE
A normal sloping curve
Mirasol
what are varriable of macro economics
maryam Reply
what is Pareto efficiency?
Kgothatso Reply
when you want to something better off you must worse off other thing
umer
What is PPF2?
Joseph Reply
how are commodities important to the country
Oriho Reply
what is the difference between real cost and opportunity cost in economy
Oriho
real costs are total money expenditure for the production of goods and services and opportunity costs is the money which is not included for production, like work of entrepreneurs in their own company
Maheswar
hi everyone how are you?
Prathana Reply
fine wbu
Abinash
fine
ALIM
hi , prathana 🍁🍁
sachin
hello sachin
Prathana
hi any indians?
Karan
I am not indian I am from Nepal 🇳🇵
Prathana
hi I'm Indian
Shraddha
ohh hi indian how are you 😅
Karan
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Karan
can you tell me prathana you like china more or india
Karan
I loved both
Prathana
oh nice
Karan
R u know ,u disturb some peoples?
Rashmi
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Shraddha
fine than you.
Haftay
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Maheswar
hello guys
Khadak
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Khadak
Hi am fine thanks for you
cabdirixmaan
Abdirahman haaye seetahay
ALIM
ALIM ABDALLA walale fiican dhankaaga
cabdirixmaan
hello
Muhammad
are you studying macroeconomics.
Muhammad
yes
Muhammad
hi every one
Khan
What is foreign reserve? Why countries reserved? And have any limitations of this reserve?
Adil Reply
what is the difference between gdp and cpi?
Luyando Reply

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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