Question

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.

Answer 1

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.