Assume a small open economy initially in equilibrium and experiencing a trade deficit. What would happen...

Assume a small open economy initially in equilibrium and experiencing a trade deficit. What would happen to the real interest rate, desired levels of saving and investment, and the net capital inflows if business investment were to increase? Answer this question with the help of a graph.

Expert Solution

In following graph, panel A shows investment and savings curves. I0 and S0 are initial investment and savings curves intersecting at point A with initial real interest rate r0 and initial quantity of investment and savings Q0.

Panel B shows net capital outflow (NCO) as an inverse function of interest rate (r).

Panel C shows net exports (NX) as an inverse function of exchange rate (e).

Therefore, NX is determined by the equality of investment and savings, which determines the interest rate.

An increase in business investment shifts I0 right to I1, intersecting S0 at point B with higher interest rate r1 and higher quantity of investment and savings Q1.

In panel B, higher interest rate from r0 to r1 decreases net capital outflow from NCO0 to NC01.

In panel C, decrease in NCO decreases net exports from NX0 to NX1, increasing exchange rate from e0 to e1.

Rahul Sunny answered 1 year ago

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Assume a small open economy initially in equilibrium and experiencing a trade deficit. What would happen...

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