Question

Explain what happens to a small open economy when foreign governments decrease their national savings. What happens to the following variables:
i. world interest rate
ii. domestic interest rate
iii. domestic investment
iv. domestic national savings
v. trade balance (or net exports)

Answer 1

The effects of foreign governments decrease in their national savings on the open economy will be as follows:

i. world interest rate: the decrease in national savings by default shifts the NFI curve towards left, decreasing the net exports of the small open country and causing an increase in the real exchange rate. If there is a war between more than one countries then the worldwide rise in government purchase can increase the real interest rate all over the world.

ii. domestic interest rate: the decrease in the national saving of the foreign government decreases the exports as well as aa imports of the domestic country and causes an increase in the domestic exchange rate. It also affects the living standards and investments of the domestic country.

iii. domestic investment: the national savings affects the domestic investment in such a manner that it becomes higher. The economy would depend on domestic capital more. When the government starts borrowing in place of saving then the trade of the country starts decreasing.

iv. domestic national savings: a decrease in national savings of foreign country will affect the domestic national savings in a manner that it will also be decreased and it will be affected negatively. When the savings will become less than the country will seek for borrowings which will again affect the economy’s GDP.

v. trade balance (or net exports): decrease in national savings of foreign country will reduce the net export and cause NFI curve to shift towards left and increase the real exchange rate of the domestic country.