Question

14. Consider the open-economy loanable funds model with flexible prices and capital mobility. Suppose that the world consists of a small open economy (we call this domestic) and the rest of the world (we call this foreign). Answer the following questions with the aid of figures where appropriate a. How does an increase in domestic government expenditure affect trade balance and real exchange rate? (2 points] b. How does an increase in foreign government expenditure affect the trade balance and the real exchange rate? How does it affect domestic investment? [2 points] Suppose that foreign demand for goods from domestie suddenly fall, how would this affect saving, investment, net exports, the interest rate, and the exchange rate for domestie? (2 points

Answer 1

a)  An increase in government spending puts pressure on the domestic currency to appreciate, leading to current account deterioration and to a decrease in consumption through an international risk-sharing condition. A rise in government spending causes a trade deficit, a real depreciation of the domestic currency, and an increase in consumption.

After an increase in government spending of 1 percent of GDP, the real exchange rate appreciates by over 3 percent on impact and by up to 5 percent two years after the shock. The effect on the exchange rate is most pronounced in countries with a flexible exchange rate.

A rise in government spending induces a real exchange rate depreciation and a trade balance deficit.

c)  An decrease in foreign demand  leads to a decrease in output and to a trade deficit . An increase in domestic demand leads to anincrease in domestic output, but leads also to a deterioration of the trade balance.