An increase of government purchases occurs after a rise in aggregate output and employment. This tends to stimulate the economy, people then tend to buy more and save less. Therefore, it results to a higher importation than exportation, known as the trade deficit. The budget deficit increases the external deficits because the exports do not proportionately increase to counterweight increase imports. This explains that a large budget deficit raises domestic interest rates and the exchange rate.
With a higher exchange rate the domestic products becomes more expensive and foreign goods cheaper. Hence, the import increases while export decreases. Resulting, the trade deficit to be enlarged. Consequently, to help drive the trade and current account of the balance of payments into deficit there is a combination of a higher interest rate and a stronger currency. However, to defend that the budget deficits mainly results from tax cuts that tend to reduce both public revenues and public saving; many researchers have justified the Ricardian equivalence hypothesis.
Nevertheless, these tax cuts are effective on reducing public savings and enlarging the budget deficit, equivalently they increase private saving by amount. However, Ricardo’s neutrality hypothesis recommended that the private sector views budget deficits as public investment and treats public and private investment as perfect substitutes. How do the CPI and the GDP deflator differ? Why do economists believe that the CPI overstates the rate of inflation? Is this an important problem? CPI is an accurate measure of inflation. When the price basket goes up so does the CPI.
It is limited to what it measures. It only measure the prices of the goods and services purchased by the urban consumers which is about 60% of the total production of the economy whilst on the contrary the GDP deflator measures the total production in the economy. It also allows to show up in the deflator the as people respond to changing prices. With this approach, the GDP deflator is being rebound up to date expenditure patterns. Despite that CPI only measure about 60% of the total production, it helps people give the idea how it affects them because it measures the type of goods they buy.
Moreover, it comes out monthly and available anytime. With the historical comparison, most of the time the CPI and GDP price deflator had the same inflation rate, and when there is a difference, they do not differ much. However, if the CPI differs from the GDP deflator, it is only by a fraction of a percentage point, even so this could be important for some economic policy decision. Many economists believe that CPI overstates the rate inflation because they think that CPI is not a good indicator of a current inflation. According to David Ranson, a U.
S. economist, a better indicator of current inflation would be increases in the price of commodities because initially inflation affects commodity prices and it will probably take several years for this commodity inflation to work its way through an economy and be reflected in the CPI. It is not an important problem so long as one is using whichever measure is appropriate for their findings. Reference Quantcrunch Tutor (April 2009 ) Q&A in Macroeconomics http://qainmacroeconomics. blogspot. com/2009_04_01_archive. html