If corporate downsizing and lack of job security cause consumers to spend less and save more,...

If corporate downsizing and lack of job security cause consumers to spend less and save more, what will be the impact on the exchange rate and trade balance?

a. Use the basic version of the long-run model of a small open economy to illustrate graphically the impact of this decline in consumer confidence on the exchange rate and the trade balance. Assume the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label:

i. the axes
ii. the curves
iii. the initial equilibrium values
iv. the direction the curves shift
v. the new long-run equilibrium values.

b. Based on your graphical analysis, explain the predicted impact of a decline in consumer confidence on the exchange rate and the domestic economy's trade balance.

Expert Solution

(a)

Lower consumer confidence will decrease consumption and increase savings. The savings curve shifts rightward, decreasing interest rate and increasing equilibrium saving and investment.

When interest rate decreases, net capital outflow increases, thereby increasing net exports (which equals net capital outflow) and decreasing exchange rate. Since net exports is identical to trade balance, this leads to higher trade balance.

(b)

In following graph, panel A depicts saving (S) and investment (I) curves. S0 and I0 are initial saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

When savings increase, S0 shifts right to S1, intersecting I0 at point B with lower interest rate r1 and higher quantity of saving and investment Q1.

In panel B (depicting net capital outflow as inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C (depicting net exports as inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1.

Rahul Sunny answered 6 months ago

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