In April 1995, Michel Camdessus, managing director of the International Monetary Fund (IMF), criticized U.S. economic policy for allowing the dollar exchange rate to fall too low. He recommended that the United States reduce its budget deficit in order to raise the exchange rate.
(a) Use the long-run model of a small open economy to illustrate graphically the impact of reducing the government's budget deficit on the exchange rate and the trade balance. 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 whether Mr. Camdessus's policy recommendation will work. Specifically state what happens to the exchange rate and the trade balance as a result of the government budget deficit reduction.