5. LO 4 Use the second model in this chapter, with production and investment, to answer this question.

The government in a small open economy is concerned that the current account deicit is too high. One group of economic advisers to the government argues that high government deicits cause the current account deicit to be high and that the way to reduce the current account deicit is to increase taxes. A second group of economic advisers argues that the high current account deicit is caused by high domestic investment and proposes that domestic investment should be taxed, with these investment taxes returned to consumers as lump-sum transfers.

(a) Which advice should the government take if its goal is to reduce the current account deicit?

Explain.

(b) Is the government’s goal of reducing the current account deicit sensible? Why or why not?

What will happen if the government takes the advice that achieves its goal, as in part (a)?