Question

Suppose the Indian central bank (RBI) increases its target overnight interest rate. In doing so it is clearly trying to increase interest rates in the money market (and throughout the economy).

(c) Suppose we could treat the Indian economy as a closed one. What effect will the results of the policy have on investment, on aggregate expenditure? Include diagrams in your answer.

(d) Although not as open to capital flows as Canada, we can think of India is an open economy. What additional effect will the policy have on aggregate expenditure?

(e) How will aggregate demand be affected, whether we treat the economy as closed or open?

Answer 1

(c) Higher interest rate will dampen investment demand, so both investment and aggregate expenditure (AE) will fall. This is explained in following Keynesian Cross diagram where initial equilibrium is at point X where initial planned aggregate expenditure (PAE) curve, PAE0, intersects 45⁰ line with initial AE being E0 and initial aggregate demand (output) being Y0. When investment falls, the investment curve shifts downward from I0 to I1, which shifts PAE0 curve downward by same magnitude to PAE1. New equilibrium is at point Y where new planned aggregate expenditure (PAE) curve, PAE1, intersects 45⁰ line with new AE being E1 < E0 and new aggregate demand (output) being Y1 < Y0.

(d) Higher interest rate, however, will attract foreign investment which will lead to higher foreign capital inflow. This will increase the demand for domestic currency, causing domestic currency to appreciate, leading to a fall in exports, a fall in net exports and lowering aggregate expenditure more than the fall in AE caused by lower investment.

(e) In an open or closed economy, higher interest rate will reduce aggregate demand.