exchange rate again pls help

Hi
Everytime i read the text on exchange rates and try to solve problems i find myself very uncomfortable.

An economy with a floating exchange rate has a deficit on the current account of its
balance of payments. Which policy combination would be most likely to solve this
problem?
A Decrease interest rates and increase income tax rates.
B Increase interest rates and leave income tax rates unchanged.
C Decrease interest rates and decrease income tax rates.
D Increase interest rates and increase income tax rates

My reasoning is like this . first of all if it is floating exchange rate CAD will automaticaly improve . So nothing to be done. It should be there for fixed exchange rate .Right?

Or otherwise, if CAD is negative means exports -imports is negative so we need to increase exports and reduce imports. This is a component of AD so means we need to increase AD . So definitely taxes should be lower.
Also i know if IR are lower then hot money would go abroad and depreciation would be there which will only increase the CAD. I think andwer should be C not D.

Also one more confusing thing is devaluation (fixed exchange rate). It increases the volume of exports and vice versa for imports. How?

 

The aim is to increase exports and decrease imports. This is more specific than just "increasing aggregate demand". You don't want to increase C,I or G; you want to increase (X-M). Decreasing interest rates and decreasing income tax will not work - they will increase C and I, some of which will be on imports (M), and this expansionary policy could also increase prices and make exports uncompetitive and so reduce exports.

In fact, you need to do the opposite, ie adopt a deflationary policy. An increase in interest rates and income tax will decrease consumption (and imports); and will also reduce any inflationary pressure and therefore make exports more competitive.

A devaluation makes exports cheaper and imports dearer, so it will increase the demand for exports and decrease the demand for imports. As long as the demands for exports and imports are sufficiently elastic, a devaluation ought to increase the current account balance.

 

As an aside, I'm not comfortable with this question. A current account deficit is not necessarily a problem, so doesn't need "fixed". I would prefer it to say something like "should the government instead with to encourage a surplus, how would it do this?"

 

Moderators, please tell me what is wrong in my logic:

1. Interest rates - When interest rates decrease, there is a cascading effect that happens in the money market and the forex market. In the money market, the fall in interest rates will cause more people to take loans, more people to convert their bonds to liquid cash, etc. Thus, the supply of money in the market will increase.
2. The interest rate fall also has an effect on the forex market. Since other countries now might have a better interest rate, "hot cash" (which is cash invested for the short term by foreign investors) will start leaving the country. Hence, the supply of foreign currency will decrease, causing the supply of forex curve to shift to the left and hence causes a depreciation of the local currency
3. This is not the only effect on the forex markets. Investors in the local country will also shift money to foreign countries where the interest rate is better. Therefore, the demand for foreign currency increases. This causes an increase in the demand for forex, causing a right shift in the demand curve and further depreciates the local currency

Since the local currency has depreciated, it is now more expensive to import and more profitable to export. The reverse applies for a decrease in interest rates

Now to the point on income taxes. This one is straightforward. An increase in income taxes (perhaps the question talks about import tariffs because that makes more sense to me than income taxes) will make the price of imports higher than it actually is and thus causes a reduction in the quantity of imports demand.

Coming to this question, my answer would be A and not D. I am hoping the moderators will correct me if I am wrong

 

Ah ... I remember this question causing some discussion when it first came up.

First of all, a floating exchange rate should (in principle) result in a current account deficit correcting itself. This is because if exports are less than imports, there will be an excess of supply of the domestic currency on the currency markets and so, all else being equal, the value of the currency will fall, making exports cheaper to people abroad and imports dearer to domestic consumers. Consequently, exports should rise and imports fall, thereby correcting the current account deficit. This is an important advantage of a floating exchange rate and so stating that the exchange rate is floating is a bit confusing in this question (April 2011 Q21).

Turning to your specific points:

(1) Yes - a fall interest rates will lead to an increased demand for money and consequently an increase in the quantity of money supplied. Likewise, an increase in the money supply will lead to a fall in interest rates.

(2) & (3) Yes - a fall in interest rates will lead to a flow of "hot money" out of the economy (by both domestic and overseas investors) , leading (all else being equal) to an excess supply of the domestic currency on the currency markets and hence a depreciation of the (floating) exchange rate.

So, all else being equal, the currency depreciation following a fall in interest rates will increase net exports / reduce a current account deficit.

However, a fall in interest rates will also increase total consumption, some of which will be on additional imports. So, the overall effect on net exports is not necessarily clear-cut.

Finally, an increase in income tax will reduce net of tax income, leading to a fall in consumption, including imports. This should therefore reduce a current account deficit.

So, the unambiguous income tax argument means that the answer to the question must be A or D. However, the ambiguity about the overall effect of interest rates on imports means that theoretically A or D could work, depending on the exact situation of the economy.

Although the examiners intended answer was D, I think a good case could also be made for A.

Going forward, the important thing is that your logic and understanding are correct.