Question

Classical small open economy model: According to the Classical small open economy model, what happens to domestic national saving, investment, the trade balance, and the real exchange rate in response to each of the following events? Draw a loanable funds market diagram and a net exports diagram to illustrate your answer in each case. (For these diagrams, let’s assume that the country starts out running a current account surplus and capital account deficit, as in the examples in class.)

a) A fall in consumer confidence about the future induces domestic consumers to spend less and save more.

b) A tax reform increases the incentive of businesses to build new factories.

c) The introduction of a stylish new domestically-produced electric car makes some consumers switch from buying a foreign-produced car to buying a domestic one.

d) The country imposes a tariff on foreign-produced goods. (For simplicity, suppose that the effect of the tariff is the following: at every value of the real exchange rate, the demand for domestic goods is higher and the demand for foreign goods is lower.) You might find it surprising that the equilibrium trade balance doesn’t change in this example; briefly give some intuition for why the Classical Small Open Economy Model implies this result.

Answer 1

A) In a classical small open economy, A fall in consumer confidence about the future induces consumers to spend less and save more. Since savings S increases, so this happens S – I. Therefore, net exports also increases. As a result the real exchange rate falls, as makes the nominal inflation rate. Subsequently the domestic price level does not change.

B) As a tax reform increases the incentive of businesses to build new factories, this will lead to increase the investment rate high and makes lower savings in the economy. This imply higher rate of interest. So, the real exchange rate falls.

C) The introduction of a stylish domestically produced foreign cars makes some consumers switch from buying foreign produced cars to domestic one. The increased demand for imports shifts net exports to the downward or leftward. This reduces real exchange rate and nominal inflation rate.