Scope for Using Fiscal Policy to Stabilize the Economy with High Public Debt

This document discusses the scope for using fiscal policy to stabilize the economy when public debt is high. It explains the impact of reducing government expenditure and implementing contractionary fiscal policies. It also explores the optimal approach and provides examples from countries like the United Kingdom.

Economics Assignment
Students Name
Macroeconomics
Course Instructor
Date

Student last name 1
Q1. Explain the scope for using fiscal policy to stabilize the economy when public debt is
high.
Notably, fiscal policy has been instrumental in the management of macroeconomic
indicators. Usually, public debt occurs when public expenditure exceeds public revenue hence
causing a deficit. In an effort to curb over expenditure in the public sector, most governments
implemented contractionary and expansionary fiscal policies to stabilize macroeconomic
conditions in the economy respectively. In the event that public expenditure depends on foreign
borrowing might lead to high public debts. In addition to reliance on foreign funding for public
expenses, overreliance on private sector loans to finance public sector expenditure might lead to
high levels of public debts.
In the event that the government does not invest more than it spends might occasion a rise
in the public debt values hence the implementation of fiscal policy1 Notably, reduced
government expenditure is more effective in curbing public debt as compared to taxation
increase. Primarily, the increase in tax rates and cutting down of public expenditure has been key
in curbing the rising public debt levels in most countries2. Fiscal policy, contractionary or
expansionary has been used to stabilize macroeconomic conditions and also curb public debt
However, reducing public expenditure is more effective in curbing the rise in public debt.
Should you engage in a fiscal stimulus or austerity? Why? What would be an optimal
approach in your opinion? Pick one country of your choice and use it as an example
In the event of high public expenditure debts, austerity seems a prudent choice. This is
because austerity provides ways to reduce the accumulation of public expenditure3. Specifically,
increased taxation regimes, reduced government expenditure are some of the most commonly
used policies to curb public over expenditure. A case in point is the United KingdomIn addition
to the UK,Greece and Spain have also cut public expenditure. Particularly, in the year 2008, the
1 World Bank Group,”Fiscal Policy for stabilization and adjustment”
2 Mohanty,”Fiscal policy,public debt and monetary policy in EMEs”
3 Corporate Finance Institute,”Exchange rate Risk”

Student last name 2
United Kingdom was in recession and implemented these policies to reduce the excessive public
expenditure at the time. Specifically, the United Kingdom government did raise the taxes to curb
the budgetary deficit at the time. In addition to increased taxation, the United Kingdom
government implemented sector budgets to curb public expenditure .
The reason for choosing austerity is because it is more effective and direct to curbing the
problem of rising public debt. This is because budget cuts for different sectors of the economy
will effectively reduce the rate of public expenditure. Whereas tax increase is effective in the
long run in reducing public debt by raising revenue, the effects are not felt immediately and it
might take time to raise the revenue required to offset the existing public debt. Reducing public
expenditure is the right course solution because it is the direct cause of rising debt. In the United
Kingdom in 2008 and Spain cases in 2011, budget cuts to public sectors of the economy yielded
results without the imposition of higher taxes.
Q2. Explain how the ECB, by setting the interest rate, has a knock-on effect on (i) liquidity
and market interest rates in the euro area;
Essentially, interest rates directly affect liquidity and market interest rates in the long and
short run. The European Central Bank has been tasked with the mandate of stabilizing monetary
and fiscal policies of the European member states thus the universal application of the interest
rate targets by its member states. Basically, liquidity implies the degree to which assets or
securities can be purchased quickly without affecting asset prices. Majorly, market liquidity
denotes selling and buying of assets at stable prices. In the event that the ECB reduces the
interest rate for its member states, the rate of borrowing in the Eurozone will increase (demand
increase). For market interest rates, an increase in the interest rates in the Eurozone will cause a
decrease in the economic activity in Eurozone economies4 .This is due to increased borrowing
costs. However, a decrease in the interest rates will cause an increase in borrowing and
investment due to low repayment rates.
4 Brauning,”The liquidity effect of the federal reserve”

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(ii) Asset prices, and thus on capital costs of firms; and (c) the value of the euro in the
foreign exchange market
Primarily, interest rates affect asset pricing. The most common types of asset include
stocks, bonds, and securities. Notably, a reduction in the interest rate will cause a rise in the
pricing of assets5 An increase in interest value raises the prices of stocks among other assets.
However, the reverse is true. In the event that interest rates rise, asset prices decrease. The reason
for the fall in asset prices when interest rates rise is due to the attractiveness of opportunity costs
at the risk-free rate.
Effect of interest rates on capital costs
Notably, interest rates affect a firm’s capital structure. This is due to the fact that interest
rates affect debt capital costs6. Most firms use equity and debt forms of capital for their
operations.in the event of debt capital, the rise in interest rate will increase the company debts
whereas a decrease in the interest rates will reduce the firm's debts hence the assertion that
interest rates have a direct impact on a firms capital costs. Basically, capital costs imply the price
payable prior to accessing funds from equity or debt pools of capital. Usually, most firms prefer
debt capital due to the tax relief associated with it. In the event that interest rates increase, capital
cost will be partially covered by tax reduction.
Euro value in the exchange market
In the event that interest rates in the Eurozone rise, the value of the Euro On the foreign
exchange market will rise as compared to other country’s currency. However, the same is not
always the case in the foreign exchange market. Mostly higher interest rates lead to more foreign
investment in the appreciated currency in foreign countries. However, a decrease in the interest
rates of foreign currency makes the currency unattractive for foreign investment7.
5 Kennon,”Why do asset prices fall when interest rates increase?”
6 White-Boyte, “How do interest rates influence corporations’s capital structure?”
7 Liourdos, “How do national interest rates affect a currency value and exchange rate”

Student last name 4
Q3. When foreign investors buy US bonds, what happens to the US capital account
balance? Explain the logic behind a capital account surplus being equal to a current
account deficit of a country. Use examples
Basically, a capital account balance implies the balance of payments of a country’s trade
with foreign countries8..In a way, the capital account balance is used to measure the economic
welfare of any country. Under the balance of payments, there are two types of account, the
current and the capital account. Whereas deficit is incurred in the capital account, the same isn’t
experienced in current accounts. For there to be an account surplus equal to the current account
trade deficit, there must be trade between the two countries. For a current deficit to occur, the
country experiencing the deficit has to import capital, services, and commodities more than it
exports.
For instance, China trades with the United States of America. In this scenario, China buys
manufactured vehicles from the United States of America. When China makes the payment
(debits) the United States capital balance account is debited whereas the Chinese Capital account
balance will be credited. In the event that the Chinese import more goods and services from the
United States of America, then it exports, the Chinese balance of payments will show a deficit in
the current account thus creating surplus on the capital account.
Q4. You are working for a big exporting company. However, in your main export market,
you are expecting a real exchange rate depreciation of 10% over the next year. What
should you do? List all options and risks that your firm might face
Options
Owing to the various risks likely to affect the firm's profits and operation costs, it is
important that firms find a way to shield themselves from currency devaluation and related risks.
Some of the ways through which exporting firms can use to cushion their profits and investment
8 Kenton,”Why do asset prices fall when interest rates increase?”

Student last name 5
from negative investment include hedging, purchase of overvalued and undervalues currencies
and lastly, engage in short currencies. Through hedging of foreign assets, the firm might be able
to cushion its financial interests from the negative effects of currency devaluation9The firm can
hide its assets from its portfolio to prevent it from foreign investment currency devaluation.
Also, through shorting of an overvalued currency, the firm might be able to prevent low
investment returns on foreign investment. This occurs when the firm identifies an undervalued
but competitive currency, purchases it and later sells it when the curre3cny has appreciated.
Basically short currencies will enable the firm to trade on future predetermined prices hence
cushioning the company from losses. In the vent that the firm purchases a currency with higher
interest rates then the firm will be cushioned against currency devaluation losses. Lastly, the firm
has the option of purchasing undervalued currencies with the likelihood of appreciating in the
short run.
Risks
Usually, firms trading with foreign firms bear the currency, exchange rate or foreign
exchange risks. In the event of currency devaluation in one currency, the other trading country
will find the goods in the devalued country cheaper hence a good time to invest. However, in the
event of currency appreciation (increase in currency value), the goods in the appreciated country
will be costly hence the likelihood of less good being purchased at the time10. Basically, the
foreign exchange risk is divided into two categories.
Namely, the firm will face economic exposure and translation exposure risks. Worth noting,
economic exposure implies the risks that will negatively affect the firm operation and
investments due to the economic conditions. In the event of currency devaluation, the operating
costs of such a firm will be on the low .Equally, the reverse is true. In the event of currency
appreciation, the operation costs will increase. The likelihood of the firm facing operating
exposure is eminent in the sense the currency depreciation will reduce the asset values of the
firm.
Notably, operation exposure is one of the risks facing exporting firms in the event of foreign
currency evaluation additionally, exporting firms firm will face translation or accounting
9 Borzykowski,”A ways to protect yourself from foreign risk”
10 Cornelius,”Exchange rate risk”

Student last name 6
exposure. Majorly, the firm’s financial statements will be affected by the currency devaluation
by 10 percent .In simple terms, accounting or translation exposure implies the risks that have a
bearing on the financial statements of an exporting firm due to foreign exchange trading. Overall,
it is imperative that exporting countries take personal responsibility in cushioning the companies
from currency risk, operation exposure, economic exposure for better returns in investments.
Bibliography

Student last name 7
Borzykowski, B. 2014. “ 4 Ways to protect yourself from foreign Currency risk”.CNBC.Com.
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Student last name 8
Mohanty, S.M. (2016). “Fiscal policy, public debt and monetary policy in EMEs: an
overview”.Bis.Org. Accessed 15 April 2019. https://www.bis.org/publ/bppdf/bispap67a_rh.pdf
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