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If a war broke out abroad, it would affect the U.S. in many ways. Use the...

If a war broke out abroad, it would affect the U.S. in many ways. Use the IS-LM model of the open economy to examine each of the following effects of such a war. What happens in the United States to saving, investment, the trade balance, the interest rate, and the exchange rate? (To keep things simple, consider each of the following separately. Furthermore, suppose no covid-19) (a) Foreign investors seek a safe haven for their portfolios in the United States.

Solutions

Expert Solution

When foreign investors find US as a safe investment haven, it will increase US national savings. The savings curve shifts rightward, decreasing interest rate and increasing equilibrium saving and investment.

As interest rate decreases, net capital outflow increases, which increases net exports (trade balance) and decreases exchange rate.

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

As 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 (showing 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 (showing 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 dencreases exchange rate from e0 to e1.

Rahul Sunny answered 2 years ago
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