n

To address the situation described, let's first write down the GDP identity for an open economy:

Y$=$C$+$I$+$G$+$NX

where:

Y is the GDP$,$

C is consumption,

I is investment,

G is government spending,

NX is net exports, which is exports $($X$)$ minus imports $($IM$).$

Given that the economy is running a trade balance deficit $($NX$<0)$ and output $($Y$)$ is below its potential level, the goal is to return GDP to its potential level without widening the trade deficit.

Medium Run Adjustments

Increase in Exports $($X$)$:

Policies that enhance competitiveness, such as improving productivity or reducing costs, can increase exports without affecting imports.

Decrease in Imports $($IM$)$:

Encouraging the consumption of domestically produced goods can reduce imports. This can be achieved through tariffs, quotas, or promoting local products.

Adjustment in Domestic Demand $($C$+$I$+$G$)$:

To eliminate the trade deficit $($NX$=0),$ domestic demand must adjust such that the increase in NX offsets any increase in C$+$I$+$G needed to reach potential GDP$.$

Government Actions

Fiscal Policy:

The government can increase spending $($G$)$ or cut taxes to boost domestic demand, but it must ensure that this does not lead to increased imports. This can be balanced by promoting domestic industries.

Supply$-$Side Policies:

Implementing policies that increase productivity and competitiveness can help boost exports and reduce the reliance on imports.

Exchange Rate Policy:

Although the exchange rate is fixed, the government can negotiate adjustments or implement measures that indirectly affect the real exchange rate, making exports more competitive.

Trade Policies:

The government can negotiate trade agreements that open new markets for exports or protect domestic industries from foreign competition.

By carefully managing these factors, the economy can aim to return to its potential output level while working towards eliminating the trade deficit.