Question

Suppose that American firms become more pessimistic and decide to reduce investment expenditure today in new factories and office space.

How will this decrease in investment affect output, interest rates, and the current account? Please include a graph thank you

Answer 1

When firms become more pessimistic towards investment, the investment demand fall. A fall in investment demand will lead to a shift in the Investment-Savings curve. The IS curve will shift left due to fall in aggregate spending. This will cause output and interest rates to fall (in the context of IS-LM model). Now consider what happens to current account (which is the trade balance of the nation). For this we consider a real exchange rate-trade balance model. As investments decreases from I1 to I2, the S-I line shifts outwards from S-I1 to S-I2. This leads to fall in exchange rate and increase in net exports. The intuition is that as exchange rate falls, the currency is valued less. This makes exports cheaper to the rest of the world. While foreign currency has appreciated and imports are costly for the home economy. Thus imports will fall. A rise in exports and fall in imports will improve trade balance. Thus current account will improve.