Question

1.List two macroeconomic factors that can be used to describe a small open economy.

Choose one of the economic factors you have listed and assume that the factor increased in one of the small economies. Briefly describe the expected effect of the change (the factor increasing) on other economic factors in the small economy and the effect on other economies (rest of the world). (You are applying your knowledge about small or large open economy here)

Answer 1

Solution

Consider a small open economies (say) Australia and Chile.

2 macro economic factors can be inflation and the level of govt.debt

I am choosing the level of govt. debt.as an example increased in Australia.

Due to the increase in the level of govt. debt. of Australia,securing additional loans by the country will become more costlier because the risk of payment default (indicated by soverign rating) will be lowered by the credit rating agencies and also some countries may reduce the payment terms and cocesions with the country.

So,the govt.borrows the additional amounts at higher interest rates which means higher outflow of money in the form of interest payments.so it is left with less money to spend on the people.so the govt might impose higher taxation on people to reduce the amount of deficit.So,the people are left with less descretionary amount to spend.So,the GDP growth reduces from previous level.Inflation becomes less.Imports become less (specially discretionary items).So the currency appreciates which means the exports will also decrease as they become costly for the other countries.

To counter this the govt.needs to reduce the interest rates in order to encourage the people to spend more.

But since the interest rates are less ,the FDI (Foreign direct investments) into the country will reduce.