Question

Suppose there is an exogenous increase in taxes,. Use the large open economy model to answer the following:

1. Does this shock affect national saving? Explain.

2. Does this shock affect net capital outflows? Explain why or why not.

3. What happens to the value of the domestic currency in the foreign exchange market? Why does the value of the domestic currency change?

4. Will net exports change? Why or why not?

5. Will the domestic real interest rate change? Explain.

6. Will domestic investment change? Why or why not?

Answer 1

1. An increase in the tax rate will reduce disposable income of the consumers. A reduction in the disposable income will reduce savings of people. As private savings decrease, the level of National Savings will decrease in the economy.

2. This leads to increase in the rate of interest in loanable funds market. An increase in the rate of interest will reduce net capital outflow from the economy which are negatively related to rate of interest in the economy.

3. An increase in the rate of interest will lead to net capital inflow in the economy and demand for domestic currency will increase. An increase in the demand for domestic currency will lead to appreciaion of domestic currency in the foreign exchange market.

4. Appreciation of domeestic currency will make exports costlier and reduce the price of imports and thus reduce net exports as exports decreases and imports increases in the economy.