Imagine a small open economy with perfectly flexible wages and prices(i.e. classical economy always at full...

Imagine a small open economy with perfectly flexible wages and prices(i.e. classical economy always at full employment) and perfect capital mobility.

Say government expenditure, private consumption and taxes are constant but investment demand fluctuates wildy.

Do Investment and the real exchange rate co-vary positively or (when one high the other is also high) negatively (one high the other is low)? explain in detail

Expert Solution

The result can be understood from the model of exchange rate determination. In this model, real exchange rate is on y axis while net exports on the x axis. The supply line is the net capital outflow (S-I). In the economy there is no change in government expense, comsumption or tax, it means total national saving is unchanged. At any given point net capital flow is constant and that is why S-I line is vertical. The real exchange rate is determined where S-I line intersects the downward sloping NX curve (lower exchange rate makes exports cheaper and increase NX). The investment demand fluctuates i.e I changes wildly! If there is a rise in amount of investment from I1 to I2 then Net capital outflow curve decreases and shifts inwards. The real exchange rate rises (as shown in the diagram).

A leftward shift of S-I means supply of dollars to be invested abroad decreases. The implication is that as investment increases in the nation, it also increases the value of the nation's currency. When its currency appreciates. imports become costlier abroad and net exports fall. Hence investment and real exchange rate co-vary positively.

Rahul Sunny answered 2 years ago

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