"The current account depends upon income and the real exchange rate. If income rises,consumption of imports is high and the current account worsens. Thus, if monetary policy is the only tool that authorities can respond with quickly, a worsening of the current account due to a rise in income (for example, because of a temporary tax cut) requires a monetary contraction to
moderate the rise in income and stop the deterioration of the current account."
(a) Use the DD-AA diagram to analyze the effects of a temporary tax cut on income and the current account.
(b) Do you find that the CA worsens and that income rises, as suggested in the comment?
(c) Now consider a monetary contraction. Use the AA-DD diagram to show its effects on income and the current account.
(d) Does this monetary policy response moderate the rise in income? Does it reverse the deterioration of the CA?