Eliminating a trade deficit
a. Consider an economy with a trade deficit (NX <0) and with output equal to its natural level. Suppose that, even though output may deviate from its natural level in the short run, it returns to its natural level in the medium run. Assume that the natural level is unaffected by the real exchange rate. What must happen to the real exchange rate over the medium run to eliminate the trade deficit (i.e., to increase NX to 0)?
b. Now write down the national income identity. Assume again that output returns to its natural level in the medium run. If NX increases to 0, what must happen to domestic demand (C + I + G) in the medium run? What government policies are available to reduce domestic demand in the medium run? Identify which components of domestic demand each of these policies affect.