Question

Use the textbook’s model of a small, open economy with perfectly mobile capital to predict how each of the following shocks will affect a nation’s national saving (S), investment (I), trade balance (NX), and real exchange rate (), all else equal. For each shock, be sure to clearly state a prediction for all four variables and illustrate your predictions with the relevant supply/demand diagrams.a.The domestic supply of capital increases(KSup)b.Domestic government purchases are reduced (Gdown)c. Forecasts of a recession cause an exogenous decrease in autonomous investment (i0down)d.A decrease in the worlds supply of loanable funds, pushes world interest rates up(rw* up)

Answer 1

Effect of following shocks on national saving (S), investment (I), trade balance (NX), and real exchange rate (e):

1) The domestic supply of capital increases(KSup)

a) Effect on National Savings

In many economic models capital and savings are considered as one. Therefore, increase in capital facilities to increase in savings and vice versa. When capital increases in the economy it leads to higher production and higher production leads to higher income. At higher income there will be higher savings. There is a positive relationship between capital supply and National Savings. Therefore increase in capital supply increases the National Savings.

C= I

b) Effect on Investment

In the above paragraph we saw that increase in capital supply increases National Savings. And it is considered that savings goes directly to investment therefore increase in capital leads to increase in investment.

c) Effect on Trade balance

Increase in capital supply increases the productivity of an economy. Therefore it also boost exports of an economy. which led to improvement in balance of trade.

d) Effect on real exchange rate

Increase in capital supply increase the productive capacity of an economy therefore economy will be able to produce more and more of goods and services, now due to higher production prices will be as much low as possible. Now a small amount of money can buy more good, therefore real exchange rate improves( increases).

2) Domestic government purchases are reduced (Gdown)

a) Effect on national savings

Decrease in governmental purchases decreases total government expenditure which leads to contractionary fiscal policy, due to which overall economy's income will be lower and at lower income there will be lower savings as well.

b) Effect on Investment

Savings and investment are proportional to each other therefore decrease in savings will also lead to decrease in investment.

c) Effect on Trade balance

At lower Investments there will be lower production of goods and services therefore lower export and balance of trade will deteriorate because of steady import demand and decrease in export.

d) Effect on real exchange rate

when there are lesser production of goods and services, in the economy higher amount of money will be chasing fewer goods and prices will go increasing. it leads to deteriorate real exchange rate.

3) Forecasts of a recession cause an exogenous decrease in autonomous investment (i0down)

a) Effect on national savings

Recession forecast decreases investor’s confidence and investment. It leads to overall decrease in production activities in the economy will lead to lesser income level add at laser income level there will be laser savings.

b) Effect on Investment

Due to recession forecast in which time will lose the confidence and at lower confidence there will be lower investment.

c) Effect on Trade balance

Recession forecast decreases investment and production activities, at lower production level economies export will decrease head it leads to deteriorated in balance of trade

d) Effect on real exchange rate

When there is decrease the production of goods and services, there will be higher money amount chasing fewer good therefore price level will increase in the economy which leads to deteriorate of real exchange rate.

4) A decrease in the worlds supply of loanable funds, pushes world interest rates up(rw* up)

a) Effect on national savings

When interest rate increases people try to use that opportunity to earn higher Returns and thus savings increases in the economy.

b) Effect on Investment

Due to higher interest rate when savings goes increasing investment will follow savings and investment will also start increasing. because whatever saved in the economy go to investment

c) Effect on Trade balance

At higher interest rates savings increases, investment increases, which lead to higher production and higher Exports which helps economy to improve its balance of trade.

d) Effect on real exchange rate

When production goes increasing because of higher investments, there will be fewer money to chase more goods and services therefore real exchange rate improve in the economy.

These were some effects of chnaging different economic variables.