Q3. The country of Zambia is a small open economy. Suddenly, a change in world fashions...

Q3. The country of Zambia is a small open economy. Suddenly, a change in world fashions
makes the exports of Zambia unpopular.
a. What happens in Zambia to saving, investment, net exports, the interest rate, and the exchange
rate and exchange rate?
b. The citizens of Zambia like to travel abroad. How will this change in the exchange rate affect
them?
c. The fiscal policymakers of Zambia want to adjust taxes to maintain the exchange rate at its
previous level. What should they do? If they do this, what are the overall effects on saving,
investment, net exports, and the interest rate?

d (i) Suppose government cuts income tax. Show in the IS-LM model the impact of the tax cut
under two assumptions: 1. The government keeps the interest rate constant through an
accommodating monetary policy. 2. The money stock remains unchanged.
(j) Use the IS-LM model and investment schedule to show the effect of a removal of
investment subsidies on investment, income and interest rate.

Solutions

Expert Solution

Suddenly, a change in world fashion makes the exports of Zambia unpopular.

(a) What happens in Zambia to saving, investment, net exports, the interest rate, and the exchange rate?

Firstly the exports will fall. This would reduce the aggregate spending, domestic income and price level in the nation. Fall in the net exports would shift the net exports curve down but saving and investment in Home country do not change. Trade balance is unchanged because this shift reduces the exchange rate and so a real depreciation increases exports once again

(b) The citizens of Zambia like to travel abroad. How will this change in the exchange rate affect them?

Now that real exchange rate has fallen, this implies foreign currencies are now expensive so it hurts them.

(c) The fiscal policymakers of Zambia want to adjust taxes to maintain the exchange rate at its previous level. What should they do? If they do this, what are the overall effects on saving, investment, net exports, and the interest rate?

They should decrease taxes so that AD shifts to the right and the interest rate rises via money market. This would increase domestic income and saving. Capital inflow will appreciate the currency and the real exchange rate will be restored.

Rahul Sunny answered 1 year ago

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