Question

Recall the small open economy model we considered, and answer the following questions for a small open economy named Atlas. For each of the slots labeled (a) through (d), indicate whether the policy listed to the leftmost column causes the variable listed in the upper row to rise, fall, or remain unchanged, and provide an explanation for your answer in each case. (13 pts)

Atlas domestic investment (3pts)

Contractionary a fiscal in Atlas

Atlas net capital outflow (3pts)

b

Atlas real exchange rate (4pts)

c

Atlas net exports (3pts)

d

  

Answer 1

A contractionary fiscal policy - is implemented say by a reduction if government purchases. Now we are considering a small open economy. Any change in economic parameters of small economy will not impact the world real interest rate. This why domestic investments remain unchanged.

Next recall that National savings S = Y-C-G. A reduction in G will increase national savings. This increases S-I from S1-I to S2-I. The S-I line denotes the net capital outflow. Here net capital outflow increases as S-I increases. Intuitively, when savings exceeds investment , the excess is lent out to other countries - which is why NCO rises. This increases the supply of home currency in the forex market. The equilibrium real exchange rate falls. Since home currency is cheaper to foreigners, the exports from Atlax become cheaper for the foreign - exports rise. While foreign currecncy relatively appreciates, making imports dearer and hence imports reduces. So trade balance improves. Net exports rise.