2. There are different ways to derive the fundamental equation. for example: Output is measured by the expenditure on it, that is, Y = C + I + G + (X – IM). Income can be used for any one of three purposes: Y = C + S + T. But output is equal to income, so C + I + G + (X – IM) = C + S + T. Subtracting (C + I +G) from both sides, and rearranging, yields: (X – IM) = (S – I) – (G – T). To explain why “Borrowing from foreigners” = (I – S) + (G – T) look at each of the terms on the right side of this equation. If I > S then the domestic economy is not providing enough savings to finance our investment; the shortfall has to be borrowed from foreigners. Similarly if G > T government spending exceeds government revenues, (T), and again the shortfall (budget deficit) must be borrowed from foreigners.

1.   Faster growth in the Japanese economy would increase American exports, and this would have a multiplied expansionary effect upon GDP. The increase in exports would imply an increase in the demand for the U.S. dollar, and consequently an appreciation in the dollar. This appreciation would reduce somewhat (but not completely) the increase in exports. On the other hand it would increase aggregate supply, and this would reinforce the expansionary effect on GDP. The effect of Japanese growth on American inflation would be ambiguous: The increase in aggregate demand would raise prices, while the appreciation of the dollar would lower the cost of imports and be deflationary.

2.   With fixed exchange rates, and inflation lower in Germany than in Italy, Italian imports will rise faster than exports, while German exports will rise faster than imports. The Italian balance of trade will move in the negative direction, and the German in the positive.

3.   When a country’s currency depreciates, its exports become less expensive to foreigners, and so exports increase. At the same time, the cost of imports, as measured in the domestic currency, increases, and so imports decrease. Hence the trade balance decreases.

4.   Under the current floating exchange rate system, fiscal policy is blunted. An expansive fiscal policy increases the demand for money, and therefore raises interest rates. This in turn attracts short-term capital inflows from abroad, which raise the demand for the dollar, and therefore raise the exchange rate. With the dollar appreciating, exports fall. Monetary policy, on the other hand, is enhanced. An increase in the money supply lowers interest rates, leading to an outflow of capital and a depreciation of the dollar, which in turn stimulates exports. Note that these effects are partially contradicted by the aggregate supply effects. An expansionary fiscal policy, leading to a currency appreciation, lowers the cost of imports and raises aggregate supply, while an expansionary monetary policy, with its attendant depreciation, reduces aggregate supply. These supply effects are much smaller than the demand effects, however.

6.   A tax cut is an expansionary fiscal policy and is likely to lead to a currency appreciation. The fiscal expansion will end up increasing the trade deficit (by reducing net exports).

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