Question

With the aid of a diagram, comment on the effect of an increase in the government budget surplus (or a decrease in the government budget deficit) on the real interest rate, desired saving, and net exports for a –

i. Large open economy

ii. Small open economy

Answer 1

1.Capital reallocation creates excess volatility in investment in many two-country open economy models. Convex adjustment costs to capital have become a standard tool to deal with this. However, current microeconomic investment models feature non-convex adjustment costs as the dominant friction. This paper analyzes fixed costs to capital adjustment in a two-country business cycle model and finds that fixed costs – unlike in closed economies – dampen aggregate investment volatilities. Moreover, convex adjustment costs can serve as a stand-in for these fixed adjustment costs when one is interested in aggregate dynamics only. Yet, the mapping between fixed and quadratic adjustment costs co-depends on other model parameters.

2.A small open economy, abbreviated to SOE, is an economy that participates in international trade, but is small enough compared to its trading partners that its policies do not alter world prices, interest rates, or incomes. Thus, the countries with small open economies are price takers. In a small open economy, factor prices are fixed at baseline levels, as international capital flows ensure that the capital-labor ratio is determined by the world interest rate that is attained in the economy. In an equilibrium, the domestic capital stock and labor supply, Lt, therefore, are determined to satisfy the firm’s profit maximizing conditions