Question

The United States, a large open economy has substantially increased government spending and decreased taxes during the early 1980s. Not only has that changed national saving in the United States, but also in the rest of the world.

(a) What was the consequence for the world real interest rate?

(b) What was the consequence of the US policy on Norway, a small open economy? Use a model of a long-run small open economy with perfect capital mobility to discuss what happened to domestic saving, investment and interest rates in Norway.

Answer 1

a),

The high interest rates of the early 1980s eventually led to a very slow growth in the United States and most other foreign economies in rest of the world. But the situation was reversed with the increase in government spending and reducing taxes by federal bank in USA to overcome the problem of recession. Due to increase in nations saving in long term, basically it helped in promoting investment but decreased outputs and profits in economy which directly effected international market regime with countries in trade at that time.Thus, this post recession period too effected other economies as -

• Lower interest rates gave a smaller return from saving. This lower incentive to save made consumers to spend rather than hold onto money thus decrease in investment.
• Lower interest rates made the cost of borrowing cheaper. It encouraged consumers and firms to take out loans to finance greater spending and investment.
• It reduced the monthly cost of mortgage repayments. This left householders with more disposable income and thus a rise in consumer spending.
• If the USA reduce interest rates, it made relatively less attractive to save money in the USA (as better rate of return in another country was available as an option). Therefore there was less demand for the Dollars causing a fall in its value. A fall in the exchange rate made USA exports more competitive and imports more expensive, thus increasing the aggregate demand.

b).

Using Mundell-Fleming model for this analysis,

The fall in the world interest rate means that the domestic interest rate is above the world interest rate and therefore, there will be an immediate appreciation of the home currency which will lead to a fall in net exports and this model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed. And at that time in USA was having floating exchange rate, thus case of expansionary situation arises. In Norway due to this exchange rate regime-

Heightened uncertainty and unrest in foreign exchange markets lead to higher risk premia on norway currency(krone). The krone came under growing pressure as a result of the sharp fall in oil prices, turbulence in international capital market and imbalances in the Norwegian economy.

The liberalisation of the capital market within a norway country required national regulatios and supervision. The liberalisation of capital movements across national borders required coordination and regulation at an international level.