Discuss about the Potential Implications for Exchange Rate.
The years of overheating would have a economic growth in excess of 3.2%, employment rate not above 5% along with inflation rate potentially above 2.5% (Abel et. al., 2011). Thus, overheating is observed in two broad period. One of the block consisting of three years namely Year 1,2&3 while the other block consists of two years namely Year 8 & 9.
Role of fiscal policy
Fiscal policy plays a critical role in the dampening of the aggregate demand which is critical for managing overheating of the economy. It typically happens when the supply is not able to keep up with the increase in demand thus leading to higher inflation and job creation but despite that a shortage continues to persist (Krugman & Wells, 2012). Such a situation, if not checked could lead to the inflation rate spiraling out with potential implications for the foreign exchange rate along with the prevalent interest rate in the market (Mankiw, 2012).
In the given case, to curtail aggregate demand, the government would need to act on multiple fronts. Firstly, it needs to decrease the disposable income available with the people which could be achieved through raising of taxes (both direct and indirect). Besides, as raising the interest rate is within the realm of monetary policy, the fiscal policy would instead ensure that there the there are restrictions on loans specially given to sectors and sections of the society that tend to enhance the inflation further (Dombusch, Fischer & Startz, 2012). Additionally, the government also needs to cut down its own expenditure as the higher the government expenditure, higher would be money available with the money and thus higher would be the aggregate demand (Beck et. al., 2011). However, if the government curtails the spending or makes it more targeted, then the disposable income with the people will also witness a gradual decline which would lead moderate the demand by causing a leftward shift as indicated below (Koutsoyiannis, 2013).
In the above figure, it is apparent that dampening the aggregate demand leads to lower inflation and lower GDP growth rate. However, this growth rate is more sustainable as the economy can growth without experiencing overheating (Krugman & Wells, 2012). Also, it is imperative to note that in the process, an enabling role also would need to be played by the tight monetary policy which would tend to increase the interest rate thereby providing incentive to the people to save and disincentive to not borrow (Mankiw, 2012).
Abel, B.A., Bernanke, B., Croushore, D.D., Kneebone, D.R., (2011). Macroeconomics (6thed.). Canada: Pearson Education.
Dombusch, R., Fischer, S. & Startz, R.(2012).Macroeconomics (10thed.). New York: McGraw Hill Publications.
Koutsoyiannis, A.(2013). Modern Macroeconomics(4th ed.). London: Palgrave McMillan.
Krugman, P.& Wells, R.(2012).Macroeconomics (3rd ed.). London: Worth Publishers.
Mankiw, G.(2012). Principles of Macroeconomics (6th ed.). London: Cengage Learning.