Question

IV. Suppose there is an increase in foreign output. a. Show the effect on the domestic economy using a two panel diagram that illustrates equilibrium output and net exports. What is the effect on domestic output? On domestic net exports? b. If the interest rate remains constant, what will happen to domestic investment? If taxes are fixed, what will happen to the domestic budget deficit? c. What must happen to private saving? Explain. d. Foreign output does not appear in equations on pg. 15 of the lecture note "The Goods Market in an Open Economy (Ch.18)", yet it evidently affects net exports. Explain how this is possible.

Answer 1

When there is an increase in foreign output then the price in the foreign country also falls which means that domestic country has an advantage importing from foreign country and foreign country export potential increases. Domestic output reduces and Net Exports reduces (b) Domestic investment will get reduced as firms will import cheaper goods from foreign country So, investment in the domestic company will have less chasm. And with that the domestic budgets deficit will have more as importing leads to flow of foreign exchange move to the foreign country And the expenditure exceeds revenue Y = C + I + G + X - M C = (a + bY) C = a + b (Y - T) Private saving = disposable income - consumption Disposable income = Y - T Private saving = Y - T - C Private saving reduces