Question

Each question must be accompanied by a graph, labeled properly. Each answer (up, down, no change) should be accompanied by a one line explanation.

For a small open economy where the world interest rate is above the rate that would prevail if it were closed (equilibrium) predict the effect of an increase in G on the following variables:

1. a) Real Interest rate

2. b) Desired Saving

3. c) Desired Investment

4. d) NX

5. e) Does the country start out with a trade deficit or surplus? (before any shift)

Answer 1

Increase in G increases budget deficit, which decreases national saving. The savings curve shifts leftward, increasing interest rate and decreasing equilibrium saving and investment. As interest rate increases, net capital outflow decreases, which decreases net exports and therefore, increases exchange rate.

Thus:

(a) real interest rate - Up

(b) desired saving - down

(c) desired investment - down

(d) NX - down

(e) Since wold interest rate is higher than domestic interest rate, initially NCO is positive, which means NX is positive, thus there is a trade surplus (exports > imports).

Graphical analysis:

In following graph, panel A shows national saving (S) and investment (I) curves for the US, with interest rate (r) and saving/investment (Q) being measured along vertical and horizontal axes, respectively. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

Panel B shows net capital outflow (NCO) as inverse function of interest rate (r). Point C represents the initial point corresponding to point A in panel A.

Panel C shows net exports (NX) as inverse function of exchange rate (e). Point E represents the initial point corresponding to point C in panel B.

Lower Japanese purchase of US securities will decrease US national savings. The savings curve shifts leftward, increasing interest rate and decreasing equilibrium saving and investment.

As interest rate increases, net capital outflow decreases, which in turn decreases net exports and thus, increases exchange rate.

In panel A, As national savings decrease, S0 shifts left to S1, intersecting I0 at point B with higher interest rate r1 and lower quantity of saving and investment Q1.

In panel B, higher interest rate from r0 to r1 (at point D) decreases net capital outflow from NCO0 to NC01.

In panel C, a decrease in net capital outflow from NCO0 to NCO1 decreases net exports from NX0 to NX1 and increases exchange rate from e0 to e1 (at point F).