If a small open economy reduces defense spending, what happens to saving, investment, the trade balance,...

If a small open economy reduces defense spending, what happens to saving, investment, the trade balance, the world interest rate, and the exchange rate? Assume that initially saving exceeds investment. I want to see two sets of graphs illustrating the effects, Make sure you explain what is going on!

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Expert Solution

As given in the question we first assume that initially savings exeeds investment.

The initial situation of the small open economy is illustrated in figure 1, the x axis represents the net exports(NX) and the y axis represents the real exchange rate(E). The savings(S₁ - I) and the net exports intersect at point A with exchange rate E₁ and the net exports NX₁ .

Now if the government reduces the defence spending, then the government savings increases which in turn increases the national savings. Since it is a open economy the investment rate depends on the world intrest rate and it is unchanged. As a result, the increase in the savings causes the (S₁ - I) line to shift towards right at (S₂ - I) as shown in the second figure. Hence, the real exchange rate falls from E₁ to E₂ and the trade balance rises from NX₁ to NX_2.

Rahul Sunny answered 1 year ago

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