Question

Suppose there is an exogenous decrease in consumption,. Use the small open economy model to answer the following:

1. How does this shock affect national saving? Explain.

2. Does this shock affect net capital outflows? Explain why or why not.

3. What happens to the value of the domestic currency in the foreign exchange market? Why does the value of the domestic currency change?

4. Will net exports change? Why or why not?

5. Will domestic investment change? Why or why not?

6. What happens to the real interest rate? Explain.

Answer 1

1.

Decrease in consumption will increase private saving, ceteris paribus. This will increase national saving, assuming public saving stays unchanged.

2.

Higher saving shifts saving curve to right, decreasing domestic interest rate. As interest rate is inversely related to net capital outflow (NCO), lower interest rate will increase NCO.

3.

Higher NCO will incraese demand for foreign currency and increase supply of domestic currency (as domestic investors will sell domestic currency to buy foreign currency for investment). Therefore, domestic currency will depreciate and exchange rate will decrease.

4.

By national income identity, NCO is equal to net exports (NX). So, higher NCO will increase NX.

5.

Domestic investment will not change immediately. But in medium run, lower domestic interest rate will increase investment.

6.

Incraese in NX will increase aggregate demand, shifting AD curve rightward. This will increase price level, causing real interest rate (= market interest rate / price level) to decrease.

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.