Question

Consider the open-economy loanable funds model with flexible prices and capital mobility. Suppose that the world consists of a small open economy (we call this domestic) and the rest of the world (we call this foreign). Answer the following questions with the aid of figures where appropiate.

a. How does an increase in domestic government expenditure affect trade valance and real exchange rate?

b. How does an increase in foreign government expenditure affect the trade balance and the real Exchange rate? how does it affect domestic investment?

c. Suppose the foreign demand for goods from domestic suddenly fall, gow would this affect saving, investment, net exports, the interest rate, and ge exchange rate for domestic?

d. the government of domestic responds to this policy in order to stabilize the exchange rate. what kind of trade policy can they implement? what would be the effects on investment, net exports, and the interest rate? What about the volume of trade?

Answer 1

a. Domestic government expenditure can increase trade. But it is necessary to evaluate on what is the government spending. The government might spend on foreign goods which will directly increase imports over exports and deteriorate the trade balance. It can also spend on subsidising the local exportable industries which would then export more and improve the trade balance. If exports increase, the exchange rate will go up, i.e. the currency will appreciate, because given the supply of domestic currency, the demand for it would increase globally with which other countries would pay for what they import from the domestic economy. For the same reason, increased import will depreciate the domestic currency because given the supply of foreign currency, the home country would demand more of foreign currency to pay for the imports.

b.

Foreign government expenditure can also increase trade. But it is necessary to evaluate on what is the government spending. The government might spend on foreign goods which will directly increase imports over exports and deteriorate the trade balance. It can also spend on subsidising the local exportable industries which would then export more and improve the trade balance. If exports increase, the exchange rate of foreign currency will go up, i.e. the foreign currency will appreciate, because given the supply of foreign currency, the demand for it would increase with which the domestic country would pay for what they import from this economy. So, the domestic currency will depreciate. For the same reason, increased import will depreciate the foreign currency because given the supply of domestic currency, the other country would demand more of domestic currency to pay for the imports. The rate of investment in the domestic currency will depend on whether the country exports more of imports more. The foreign country can also directly invest in the domestic country in which case the rate of investment will rise.

c.

If foreign demand for domestic goods fall, it will adversely affect the domestic economy. Savings will reduce because income will reduce. Investment will reduce because there will be lesser production now. Because of this, in the loanable funds market the interest rate will reduce as for constant supply, the demand for loanable funds reduces. Exports will reduce because demand for goods is less internationally. Thus, the demand for domestic currency in the foreign market will reduce, for constant supply. Which will lower the exchange rate and cause the domestic currency to depreciate.

d. If the government of the domestic country wants to change the situation, the best way is to subsidise the export industries so that the price of tradeable goods can fall. This will bring about more foreign demand for these goods. This will boost the investments rates and also the interest rate. The government can also ease the tax norms for these industries thus inventivising more production. The exports will rise as a result. And the exchange rate will thus appreciate because of increasing demand for domestic currency in the foreign market.