In the late 1980s, the United States had a large government budget deficit and a large current account deficit. The dollar was floating. One approach suggested to reduce both of these deficits was a large increase in taxes.
a. If the exchange-rate value of the dollar remained steady, how would this change affect U.S. domestic product and income? How would it affect the U.S. current account balance and the U.S. financial account balance? Explain.
b. What are the possible pressures on the exchange-rate value of the dollar as a result of this change in fiscal policy? Explain.
c. If the dollar actually depreciates, what are the implications for further changes in U.S. domestic product and the U.S. current account balance? Explain.