3. S-I(r) and NX

Suppose that governments around the world begin to engage in expansionary fiscal policy (run large budget deficits) in order to stimulate economic activity in their countries.

a) Use the long-run model of a small open economy to illustrate graphically the impact of this expansionary fiscal policy by foreigners on the U.S. exchange rate and the trade balance. Assume that the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values.

b) Based on your graphical analysis, explain the predicted impact of the foreign expansionary fiscal policy on the U.S. exchange rate and the U.S. trade balance.