Expenditure dampening policies may be used to correct a current account deficit. This involves contractionary monetary and fiscal policy. I understand that such measures induce a reduction in consumption, investment, and government spending and may lead to a fall in aggregate demand. But how can we be so sure that the rise in net exports won't counteract the fall and make AD rise? Is this not a common case? In short, what is the usual effect of dampening policies on AD?
The effect of trade would normally only partly counter-act the dampening policy.
It is of course possible that a change in net exports is greater than the effect of the dampening policy if multiple things are changing at once (like in the real world). I will just discuss what happens if all else is assumed to be unchanged.
My discussion is based on model OPEN, from “Monetary Economics” by Wynne Godley and Marc Lavoie (Link to code at sfc-models.net). I will just do some back-of-the-envelope approximations.
We assume that imports are a fixed percentage of demand (20%), and we have two identical economies (which start out with balanced trade). We then assume that Country A enacts a policy that reduces domestic demand by 5%.
- Exports would be (roughly) unchanged, since Country B kept policies unchanged. (This is an approximation, since the drop in growth in A would also reduce growth in B via its export industry.)
- Imports drop by 5% relative to their previous level, which is an amount that is 1% of total demand (since imports are 20% of domestic demand).
The net result is that there is only a 1% offset from trade against the 5% demand contraction from policy.
In order for there to be no effect, we would need the entire drop in domestic demand to come from imports. There might be some special cases where this happens (e.g., the government stops importing foreign equipment), but such selectivity would not be possible with something like interest rate policy.