Question

1. (10 pts) An open economy is defined by the identity: Y = С + I + G + NX; where Y=real GDP 1-1(r), NX- Net exports (real exchange rates), C=C(Y-T), T=lump sum taxation and G-exogenously determined governmental expenditures. Assume an economy's loanable funds market is initially at equilibrium, r and $. After a recent survey, it is determined that consumers are pessimistic about their economic well being and plan to reduce their level of consumption. What will be the net effect of this change in consumption on real exchange rates and real interest rates? (Use the loanble funds market). .

Answer 1

as we know the equilibrium in the lonable funds market is determined by the forces of demand and supply. and saving is a source of lonable fund. so if consumption declines that ultimatly means increase in lonable fund and as the general principle of demand and supply works here also as supply of lonable fund will increase more than demand the rate of interest will decline. so the effect of decline in consumption will finaly lead to decline in rate of interest in the country.

the effect on exchange will depend ultimately on the effect of interest rate because as we know the home countrys currency will be stronger if the rate of interest is high. the high interest will attract a lots of investment from foreign countrys which will make the home countrys currency stronger and the exchange rate will decline for the home country but as in this case the rate of interest has declined the exchange rate will also decline because there will be a huge amount of currency outflow from the country and this will make the currency weaker and the exchange rate will increase.