Fiscal Policy and Economic Responses

The video discusses the impact of a terms of trade shock on a commodity-exporting country with a pegged exchange rate, referred to as Country A. It explores policy options for both transitory and persistent shocks, including fiscal policy adjustments and exchange rate strategies. The video also examines the benefits and challenges of preserving a currency peg and the need for fiscal consolidation. A case study of Saudi Arabia illustrates gradual fiscal consolidation in response to declining oil prices. The Swan diagram is introduced as a tool for analyzing macroeconomic policy options.

What is a terms of trade shock?

• A rapid increase in domestic inflation

• A sudden change in the exchange rate

• A sudden increase in foreign investment

• A significant change in the price of a country's exports relative to its imports

What is a potential policy response for a transitory shock in a commodity-exporting country?

• Increasing interest rates to curb inflation

• Using expansionary fiscal policy to support economic activity

• Reducing government spending

• Implementing strict capital controls

How can a country adjust to a persistent terms of trade shock?

• By implementing strict wage controls

• By increasing foreign aid

• By devaluing its currency to improve competitiveness

• By increasing tariffs on imports

Why might a country choose to devalue its currency in response to a persistent shock?

• To reduce foreign debt

• To increase domestic inflation

• To improve the current account balance

• To attract foreign investment

What is a benefit of maintaining a currency peg?

• It allows for rapid economic growth

• It eliminates the need for fiscal policy

• It provides a stable nominal anchor for policy makers

• It guarantees a trade surplus

What is a potential downside of rapid fiscal consolidation?

• It eliminates the need for monetary policy

• It may cause short-term economic pain

• It can lead to a trade surplus

• It guarantees long-term economic growth

What role do fiscal and external buffers play in a country's response to a shock?

• They ensure a fixed exchange rate

• They determine the speed of fiscal adjustment

• They eliminate the need for currency devaluation

• They guarantee a balanced budget

What was a key strategy used by Saudi Arabia in response to falling oil prices?

• Increasing oil production

• Abandoning the currency peg

• Implementing rapid fiscal consolidation

• Opting for gradual fiscal consolidation

What is the impact of a pegged exchange rate on monetary policy?

• It enhances monetary policy credibility

• It leads to higher inflation rates

• It allows for flexible interest rate adjustments

• It limits the central bank's ability to control inflation

How did Saudi Arabia prepare for potential fiscal risks from oil price fluctuations?

• By abandoning its currency peg

• By reducing its oil production

• By building up large financial assets

• By increasing its foreign debt