Aggregate Income, the Exchange Rate, and the Trade Balance - Essay Example

In the following, we consider the effects of certain exogenous changes on the equilibrium.

(a) Reduction in the income tax rate

Figure 2: Effect of a reduction on taxes: F is the new equilibrium

A reduction in the income tax rate leads to the following changes:

1. Planned consumption expenditure rises due to a bigger disposable income which in turn leads to an expansion in real aggregate output (Y) at each interest rate. So, the IS curve shifts to the right.
2. This tends to raise the interest rate i above I* which in turn leads to a huge inflow of capital. This leads to a tendency for the domestic currency to appreciate. In order to prevent this appreciation so that the exchange rate remains at its pegged value, the central bank has to buy up the excess foreign currency.
3. This buying of foreign currency, in turn, leads to an increase in the International Reserves of the economy, and therefore, the monetary base of the economy expands which in turn leads to a rise in the money supply. Consequentially, the LM curve also shifts outwards.

Thus, the final impact is a large expansion of aggregate income, while the exchange rate and the trade balance remain unaltered. 

1. The reduction of the monetary base will reduce the money supply with a multiplier effect and so, the LM curve will shift inward as well.
2. By now it should be evident that this case is the exact opposite of case (a). The final result is that the aggregate income falls, while the exchange rate and the trade balance remain the same.

(c) Removal of Quota on imported Cars

1. The removal will lead to a decline in net exports (imports will rise relative to exports). So, the IS curve will shift downwards.
2. The rest of the sequence is identical to case (b).

The final result is that the aggregate income will fall, the exchange rate will remain the same and the trade balance will worsen.

(d) Reduction in money demand

This situation will have no impact on the initial equilibrium at all. All variables will retain their initial values.