The figure shown in this exercise should be familiar to you. The top panel shows the relationship between demand for a country’s goods and services and its output. The bottom panel shows the relationship between that country’s net exports and its output. If this figure is not familiar go back to

• Equilibrium output and net exports: increase government spending and
• Equilibrium output and net exports: increase foreign demand

A tool available to governments beyond fiscal policy and monetary policy is changing the exchange rate. The exchange rate represents the rate that domestic currency (dollars in the U.S.) can be exchanged for foreign currency (yen in Japan, for example). Because foreign consumers must obtain dollars to buy U.S. goods (U.S. exports) and U.S. consumers must obtain foreign currency to buy foreign goods, changes in the exchange rate affect net exports. In fact, when the U.S. dollar depreciates (loses value), foreign goods become more expensive than domestic goods. Subsequently, U.S. exports rise and imports fall, resulting in a rise in net exports. An appreciation (gain of value) of the U.S. dollar works in the opposite direction. Let’s use this information to attempt to get rid of a trade deficit without changing output.

Suppose the U.S. faced a trade deficit at its current level of output (as shown by the line between points B and C in the lower graph).

1. How can U.S. government officials change the exchange rate to eliminate the trade deficit ?
2. Given your answer to question 1, how does the change in the exchange rate shift the net exports line ?
3. Has U.S. output remained constant ?
4. What type of fiscal policy can the government use to return output to its initial level ?
5. Is there a trade deficit or trade surplus ?
6. Can you adjust the exchange rate (shift the NX′ line) and use fiscal policy (shift the ZZ′ line) until output is equal to its original level and the net exports are equal to zero ?