Question

Consider the following scenario in a large open economy using the loanable funds model (long run), suppose there is a technological breakthrough that increases investment demand

a. graph and explain what happens to savings, investment , the real interest rate,net capital flows, net exports and the real exchange rate

b. compare what happens to the level of investment in a closed conomy to the level of investment in a large open economy

Answer 1

a. When investment demand increases, the IS curve shifts to the right. At this point, the money market is in disequilibrium. Hence, the interest rate starts increasing to clear the money market. As soon as the interest rate increases, there is capital inflow because of the higher rate of interest in the home country as compared to the foreign countries. This creates an excess in the Balance of Payments account. Now, because of capital inflow, there is an increase in foreign currency as more foreign currency is required to be converted into the domestic currency in order to purchase goods and services. This leads to an increase in supply of the foreign currency and reduces the equilibrium real exchange rate (domestic currency per foreign currency). Because of the rise in imports, the IS curve shifts backwards with the BP (Balance of Payment) curve. This creates a new equilibrium point where output and interest rate are higher than the original level of output and interest rate.

b. With an increase in investment demand in a closed economy, the IS curve shifts to the right to reach a new equilibrium level at which the output and interest rate are higher than the original output and interest rate level. Compared to an open economy, the level of investment and savings in a closed economy is higher because of lower crowding out by the market for foreign currency.