In: Economics
Suppose Country X is a small open economy with a huge trade
deficit.
Recently, her government suggests a reduction in income tax. Using
the Classical Theories, explain what will happen to net capital
outflow and real exchange rate in the long run.
Explain the impact on the size of her trade deficit.
Since the country is a small economy, it means it cant affect the world interest rate. This means r is given. The country also has very high trade deficit, which means its Net Exports, NX, is negative.
Since NX=S-I, which means its investment, I, is greater than its savings S
S We also know that Net exports=Net Capital outflow=S-I. An decrease in taxes would reduce savings, shifting the savings
curve to the left. There will be no change in investment cause that
is being determined by the world interest rate. Savings would
reduce further. Since Net Capital outflow=S-I, and I is not changing while S is
decreasing, its Net capital outflows would become further negative,
effectively decreasing. And since we already established that trade
deficit=exports-imports=NX, trade deficit will further
increase. In the long run, the country's real exchange rate would rise,
since exchange rates and net exports have an inverse relation. This has been shown in the graph below. r is fixed as world interest rate. Because of that I is also
given and doesnt change when the government reduces taxes. S shifts
to the left as it reduces, decreasing the Net Exports to
NX2 from NX1.