Question

Each question must be accompanied by a graph, labeled properly. Each answer (up, down, no change) should be accompanied by a one line explanation.

For a small open economy where the world interest rate is below the rate that would prevail if it were closed (equilibrium) predict the effect of an increase in G on the following variables:

a) Real Interest rate b) Desired Saving c) Desired Investment d) NX e) Does the country start out with a trade deficit or surplus? (before any shift)

Answer 1

a. For an open small economy, fiscal expansion or rise in G leads to IS curve moving right, with no change in money supply. This causes real interest rate to rise domestically.

b. Due to fiscal expansion, public savings fall.

and Desired savings = Public savings + Private savings. Further,

S = I + CA balance = I + NX

With NX falling, CA deficit increasing, and fiscal expansion Desired savings falls.

c. From above explanation in part b. Desired investment too falls.

d. Net exports falls - This is because as real interest rate increases capital flows in, increasing supply of dollars and appreciating domestic currency. As domestic currency become stronger, Net exports are expensive so it falls.

e. As the country is a small economy it cannot affect world interest rates. Also initially world interest rate was at lower levels (S<I) than domestic real interest rates ( where desired savings= desired investment). Therefore it started with trade deficit , and foreign lending/ borrowing to fill the deficit.  

All the changes from a to e are shown in the figure below.

This shows the initial state of economy, then how fall in desired savings ( S_{​​​​​d} moves leftwards) due to fiscal expansion leads to rise in domestic interest rate and fall in desired investment. Further it leads to widening of trade deficit.

In second figure , fiscal expansion shifts IS curve outwards, raising exchange rate. The effect of exchange rate appreciation is shown in net export curve.NX falls as shown.