4.1 Suppose that interest rates in Australia rise relative to those in other countries. (a) How...

4.1 Suppose that interest rates in Australia rise relative to those in other countries.

(a) How will this policy affect real GDP in the short run if Australia is a closed economy? (b) How will this policy affect real GDP in the short run if Australia is an open economy? (c) How will your answer to part b change if interest rates also rise in the countries that are the major trading partners of Australia?

Expert Solution

a) Interest rate in Australia rise and Australia is a closed economy, investors of Australia are left with no other choice other than borrow at a higher interest rate which will hit the level of investment that take place in country. On the other hand, people who have spare money will prefer to keep it in bank to earn higher interest rate. Both of these factors will reduce investment level. As Investment and aggregate demand have positive relationship with each other, fall in level of investment will reduce aggregate demand in the economy in short run.

b) If Australia is open economy and interest rate in Australia is rising relative to other countries, it will attract alot of foreign investment because they can earn higher rate of interest in Australia. On the other hand, domestic investors will try investing in other countries because they can get a loan at lower interest from there. So, the effect on real GDP will be ambiguous which is dependent on the inflow and outflow of cash.

c) If interest rate in other countries also fall, it will decrease level of investment as well as real GDP for a while till investors understand that they are left with no other option other than borrowing at higher interest rate which will again raise the real GDP level.

Rahul Sunny answered 1 year ago

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