Question

Consider a reduction in (domestic) taxes (T). a. Consider the event in the long-run closed economy model. How will private and public savings be affected? Explain. Illustrate graphically using the domestic loanable funds market how such an event will affect the equilibrium domestic national savings, domestic investment spending and domestic real interest rate. Explain. b. Consider the same event, but now in the long-run small open economy model(Assume the economy is originally running a trade deficit.) I llustrate graphically using the domestic loanable funds market how such event will affect the equilibrium domestic national savings, domestic investment spend hg, net capital outflow and domestic real interest rate. Explain how the differences in the results obtained here from the results obtained in (a) come about. Consider again the same event in the long-run small open economy context. Illustrate graphically using the "foreign exchange market how such event will affect the equilibrium net exports and the real exchange rate. Will domestic currency appreciate or depreciate? Explain.

Answer 1

CLOSED ECONOMY MODEL:-

Closed economies are defined as countries that are self-sufficient and autarkic. A widely used analogy by Economics professors is Robinson Crusoe’s island, since Crusoe was unable to trade. This one-man economy is the easiest way to understand closed economies.

Saving & Investment are two crucial elements of macro-economics. The term Saving & Investment sometimes make us confusing & we use these terms in interchangeably. So concept of Saving & Investment should be cleared.

Saving is closely related to investment. By not using income to buy consumer goods & services, it is possible for resources to be invested by being used to produce fixed capital, such as factory & machinery. Saving can therefore be vital to increase the amount of fixed capital available which contributes to economic growth.

Closed economy with public deficit or surplus possible

Public saving, also known as the budget surplus, is the term (T − G − TR), which is government revenue through taxes, minus government expenditures on goods and services, minus transfers. Thus we have that private plus public saving equals investment.

However increased saving doesn’t always refers to increased investment. If saving is not deposited in a financial intermediary like bank or stashed for any reason there is no chance for those savings to be recycled as investment by business.

Long run small open economy MODEL

The small open economy takes the real interest rate as given (so is exogenous). If output exceeds the total spending, we export the difference, and NX is positive (trade surplus).

Because it is a long run model, we can apply classical dichotomy. That is, we first determine real variables (such as net export and real exchange rate), then we determine nominal variables (such as nominal exchange rate) Because the economy is open and small, the domestic real interest rate must be the same as world real interest rate (otherwise international arbitrage would make it so). So unlike the big closed economy in which real interest rate.

adjusts to equilibrating saving and investment (so is endogenous), the small open economy takes the real interest rate as given (so is exogenous).