Question

Use the model of the small open economy (Apply the small open economy model of real exchange rate determination ) to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events. draw a graph (be sure to label all points, shifts and curves) and provide a short verbal analysis of the impact on the trade balance, the real exchange rate and the nominal exchange rate).

1. A fall in consumer confidence about the future induces consumers to spend less and save more.
2. A tax reform increases the incentive for businesses to build new factories.

Answer 1

1. A fall in confidence of the consumers about the future will enable them to save more and consume less. The less amount of spending in the economy will lead to decrease in the imports of the country. The aggregate demand in the economy also decreases with the decrease in level of spending. Fall in aggregate demand also decreases the net exports and hence the real and nominal exchange rate also falls. The diagram below shoes the effects of decrease in consumption. the fall in level of spending shift the AD curve towards left.
2. The increase in the incentive for businesses to build new factories will attract more foreign capital and will also increase the exchange rate of the country. The trade balance of the country will become negative as the increase in exchange rate will decrease the exports of the country. The diagram demonstrate the effect of increase in investment on aggregate demand curve. The AD curve shifts leftwards because of increase in investment.