Question

The Open Economy Model

Assume that in a small open economy with full employment, consumption depends only on disposable income. National saving is 300, investment is given by I = 400 – 20r, where r is the real interest rate in percent, and the world interest rate is 10 percent.

1. If government spending rises by 100, does investment change? What is the level of investment after the change?

2. Does the trade balance change if G rises by 100? If it changes, does it increase or decrease, and by how much?

3. Does net capital outflow change if G rises by 100? If it changes, does it increase or decrease, and by how much?

4. Will the real exchange rate rise, fall, or remain constant as a result of the change in G? Show it in a graph, and explain the results.

Answer 1

i) No, the level of investment does not change, it remains the same. In an open economy, interest rates are fixed by the world interest rate. So in this case investment would equal
I=400-20×10
400-200= 200

ii) Yes, the trade balance changes, it decrease by 100. The national savings in the question is given to us as 300. The domestic investment we calculated in part a as 200. So the trade balance is 300-200 = 100.

iii) Yes, the net capital outflow decreases by 100. Net capital outflow calculates the amount of funds being invested foreign. In this situation, the small open economy wants to invest 300 as savings is 300, but there is only room for 200 to invest domestically. So 100 is invested abroad and the net capital outflow would be 100.

iv) The real exchange rate will rise as the government spending rises by 100.
   In the exchange rate concept, one nation's currency can be exchanged for another nation's currency. It decides how economical or how costly it is for us to purchase goods. The increase exchange rate for the U.S. dollar makes foreign currencies inexpensive , which decrease the amount of imports. It means we can purchase goods and services.

diagram 1