APMacro: Monetary and Fiscal Policies Impact on Foreign Exchange

Changes in a nation’s monetary and fiscal policies affect its exchange rates and its balance of trade through the interest rate, income and the price level. Changes in the value of a country’s currency may affect the balance of trade and aggregate demand. The value of real output and price levels may also be affected. Domestic policies influence currency values, and currency values influence domestic policies. The complexity of the connection leads to careful evaluation of any change in domestic policy goals. Policy makers cannot ignore the international effects of changes in monetary and fiscal policies.

Consider the following situation. The U.S. government initiates a personal income tax reduction plan, leaving every tax-paying American with more disposable income. What will happen as a result to trade between the United States and Taiwan?

Monetary Fiscal Foreign Exchange - Taxes

The increase in disposable income increases the demand for all goods, including foreign goods. The increase in U.S. prices makes foreign goods less expensive. Therefore consumers buy more foreign imports. The relative price to foreigners of U.S. goods has increased, so foreigners buy less exports.



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