Question

3. 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 Atlas net capital Atlas real exchange Atlas net exports investment (3pts) outflow (3pts) rate (4pts) (3pts) d b с Contractionary fiscal in Atlas

Answer 1

a.domestic investment - falls
Reason - A contractionary fiscal policy raises interest rates owing to decrease in money supply. So, borrowing money for investments is costlier. Hence, domestic investment will fall.

b. net capital outflows - fall
Reason - As interest rates increase due to contractionary fiscal policies, people of Atlas would compare their rising domestic interest rates to the foreign interest rates, and hence, inflows would increase, so, net capital outflows decrease.

c. real exchange rate - falls
Reason - Contractionary fiscal policy would would decrease the demand for Atlas' domestic currency(depreciation). Hence, real exchange rate declines, as people would want less of currency from Atlas.

d. net exports - rises
Reason - When using contractionary fiscal policy, the domestic currency of Atlas depreciates, hence, people from other countries would want to buy more from Atlast. Thus exports increase and imports get costlier for Atlas. Hence, net exports increase.