Question

Compare the impact of an increase in the government's budget deficit on national saving, interest rate and investment spending in two cases: a small open economy and a closed economy. The two economies are otherwise comparable. Assume prices are flexible and that factors of production are fully employed in both economies. Assume there is perfect capital mobility for the small open economy. (125 words maximum)

Answer 1

National Saving = I + NX

where I: Investment, NX: Trade Balance

Incase of Closed economy: NX= 0, therefore, National Saving = Investment

When Government Spending increases, it leads to lower public savings leading to a fall in national savings in the case of the closed economy. Therefore, investment decreases in the case of a closed economy. The expansionary fiscal policy i.e. increased government spending leads to rise in interest rates in the closed economy due to the rightward shift of the IS curve.

In the case of a small open economy, increased government Spending increase leads to lower public savings leading to a fall in national savings. Since it is a small economy, the interest rate is set by the world and doesn't change due to perfect capital mobility and hence there is no change investment, and therefore, a decrease in national savings leads to an equal amount of decrease in NX.