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? (explanation and graphs)

Answer 1

To expalin the impact on current account, I have used two diagrams - IS-LM and the Real exchange rate-Trade Balance model.

When there is a reduction in investment expenditure, there is a fall in aggregate expenditure which causes IS curve to shift left from IS1 to IS2. This causes interest rates to fall from r1 to r2 while output falls from Y1 to Y2.

The current account indicates the trading capacity of a nation or in other words the trade balance of a nation. For this analysis consider the exchange rate-trade balance model. A decrease in Investment from I1 to I2 means that the S-I2 is greater than S-I1 and the S-I line shifts outwards. This causes a decrease in real exchange rate. A fall in exchange rate decreases the value of home currency and thus exports are cheaper for the rest of the world - which increases exports of the nation. While a fall in value of home currency makes imports costlier fot the rest of the world, thus reducing imports of the nation. Hence there is an improvement is the trade balance and hence an improvement in current account. In the graph we can see the trade balance increases from NX1 to NX2.