Question

Suppose that Congress and the President enact legislation that provides a tax rebate to businesses to purchase capital goods. Assume other countries make no policy changes. You can write up, down, or flat in the boxes.

	US real interest rate	US Domestic Investment	US Net Capital Outflow	US Real Exchange Rate	Net Exports
A decline in Investment Demand
An Increase in the Savings Rate

Answer 1

	US Interest rate	US Domestic investment	US Net capital outflow	US real exchange rate	Net exports
1. Tax rebate to business	Increase	Increase	Decrease	Increase	Decrease
2. Decline in investment	Decrease	Decrease	Increase	Decrease	Increase
3. Increase in savings rate	Decrease	Decrease	Increase	Decrease	Increase

EXPLAINED:

(1)

A tax rebate to business will increase investment. This will shift investment demand curve rightward, increasing domestic interest rate and investment. Since interest rate and net capital outflow are inversely related, higher interest rate will decrease net capital outflow. Since net exports equal net capital outflow, lower net capital outflow will decrease net exports. Finally, since exchange rate and net exports are inversely related, lower net exports will increase exchange rate.

In following graph, panel A shows Investment and Saving curves. I0 and S0 are initial investment and saving curves intersecting at point A with initial interest rate r0 and initial investment & savings Q0. When I0 shifts right to I1, it intersects S0 at point B with higher interest rate r1 and higher investment & savings Q1.

In panel B (showing net capital outflow as inverse function of interest rate), higher interest rate from r0 to r1 decreases net capital outflow from NCO0 to NC01.

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

(2)

A decline in investment demand will shift investment demand curve leftward, decreasing domestic interest rate and investment. Since interest rate and net capital outflow are inversely related, lower interest rate will increase net capital outflow. Since net exports equal net capital outflow, higher net capital outflow will increase net exports. Finally, since exchange rate and net exports are inversely related, higher net exports will decrease exchange rate.

In following graph, panel A shows Investment and Saving curves. I0 and S0 are initial investment and saving curves intersecting at point A with initial interest rate r0 and initial investment & savings Q0. When I0 shifts left to I1, it intersects S0 at point B with lower interest rate r1 and lower investment & savings 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 decreases exchange rate from e0 to e1.

(3)

An increase in savings rate will increase savings. This will shift savings curve rightward, decreasing domestic interest rate and increasing investment. Since interest rate and net capital outflow are inversely related, lower interest rate will increase net capital outflow. Since net exports equal net capital outflow, higher net capital outflow will increase net exports. Finally, since exchange rate and net exports are inversely related, higher net exports will decrease exchange rate.

In following graph, panel A shows Investment and Saving curves. I0 and S0 are initial investment and saving curves intersecting at point A with initial interest rate r0 and initial investment & savings Q0. When S0 shifts right to S1, it intersects I0 at point B with lower interest rate r1 and higher investment & savings 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 decreases exchange rate from e0 to e1.