Question

5. Consider a small open economy that is currently running a trade deficit. a. With the help of a graph, what would happen to the real interest rate, the trade deficit, and desired levels of saving and investment if government expenditures were to increase? b. With the help of another graph, what would happen to the real interest rate, the trade deficit, and desired levels of saving and investment if consumption expenditures were to decrease?

Answer 1

b. a) The small open economy takes the world interest of as given and it is determined in world financial market. The supply of savings is constant and given as: š=e.c o The demand for savings is domestic investment demand I(r) which is a negative function of real interestr. At ang given n; the difference between between sc swoings (i) and investment 3(%) in net export (^x) 'Nx = 5-1(r) For s> 1() ; Nx>0. there is trade Spм. for sc I(r) i NX< o trade - there in deficit This economy starts from trade deficit NX CO ;. this in this economy SC I(7) at world interest rate . . . As G increases ; from ar Savings equation i decreases. That is level of savings decreases. world r* At world interest 307 rate (**) level of investment in constant at Io. A fall in h 3 widens the gap between s and Ilog. Hence as a result trade deficit widens rises, NX << LA

6) As c falls; from savings equation , Š rises. Now this can have the outcomes. The rise in š increases nx ; it can make trade deficit falls to zero and even can make trade balance a swephs or it can make deficit fall the result depends on the magnitude of rise in c and its effect on savings. As small open economy takes world interest as given, level of investment and real interest remain the same after rise in c... -world interest - rate deficit - ICT) - E šo ši si Initial trade deficit : Sosi After ise fall inc there can be three cases Case I: 5 NX <o but fails to sís case 31: Nx=0 case 551: 5143 Nx >0