The following points highlight the top three effects of economic policies on the RER. The Effects are: 1. Effect of domestic fiscal policy 2. Effect of fiscal policy abroad 3. Increase in investment demand.
Effect # 1. Effect of Domestic Fiscal Policy:
Suppose that the British government now reduces national saving either by increasing G or cutting T.
As a result the national S – I curve, shown in Fig. 6.7, shifts to the left and trade deficit increases.
So the question here is: how the equilibrium RER adjusts to ensure that NX falls? Due to a leftward shift of the S – I curve there is a fall in the supply of pounds to be invested abroad.
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This raises the equilibrium RER from er0 to er1. This means that pound appreciates in terms of other currencies (or, what comes to the same thing, other currencies depreciate in terms of pound).
Effect # 2. Effect of Fiscal Policy Abroad:
If foreign governments increase G or reduce T, world saving will fall and world rate of interest will rise. This will lead to a rise in the domestic investment. So, S – I = NX will rise. Thus an expansionary fiscal policy abroad generates a balance of trade surplus by increasing r.
Fig. 6.8 shows that due to policy induced rightward shift of the vertical S – I line the supply of pounds, seeking investment outlets abroad, rises. This is equivalent to an excess supply of pound, which causes the equilibrium RER to fall. This means pound becomes less valuable and domestic (British) goods become less expensive in relation to foreign goods.
Effect # 3. Increase in Investment Demand:
If the government gives incentives to investors in the form of investment tax credit, or investment subsidy, the investment demand curve will shift to the right. This means that more investment is made at the prevailing world interest rate. This implies a fall in S – I = NX. Thus, a fiscal boost creates a trade deficit,
Fig. 6.9 shows that a leftward shift of the vertical S-I line reduces the supply of pounds to be invested abroad. This shortage of pounds in the world financial market raises the equilibrium RER. Thus, we find an interesting development.
When an investment subsidy makes investing in the UK more attractive, it also increases the value of pound necessary to undertake more profitable ventures. But a rise in RER or appreciation of the pound makes British goods now more expensive than foreign goods. This discourages exports, encourages imports and leads to a fall in NX, i.e., trade surplus falls (or, trade deficit increases).
