Question

The country of Solidia is politically very stable and has a long tradition of respecting property rights. If several other countries suddenly became politically unstable, we would expect Solidia’s

a. real interest rate to rise.

b. real exchange rate to rise.

c. net exports to rise.

d. None of the above is likely.

Please don't just tell me the answer. Please walk me through the process of how you came to choose the answer. I am confused.

Answer 1

Real interest rate is determined in the market for loanable funds, and real interest rate is the price of loanable funds. The equilibrium interest rate at which supply and demand of loanable funds are equal is the real interest rate.

When other countries become politically unstable, the investors of other countries, and Solidia, will want to invest in Solidia as Solidia is politically stable and respects property rights. So, there is less chance for the investors to lose money.

This causes excess supply of loananble funds in Solidia. The demand for loanable funds will remain the same, as there is no factor affecting the demand. By market mechanism, real interest rate will go down in Solidia.

So, a. is incorrect.

Now, as Solidia is politically stable while other counties are not, people will want to buy Solidia's currency as their store of wealth. This increases the demand for Solidia's currency, while there is no change in its supply. So, there is excess demand for Solidia's currency in the foreign exchange market. By, market mechanism, real exchange rate goes up.

So, b. is correct.

There is no effect on the exports and imports.

So. c. is incorrect.

Hence, b. is the correct answer.