In Mankiw’s model of a small open economy, domestic interest rates are set by the world’s market for loanable funds, rather than by domestic saving and investment.

a. What are the two simplifying assumptions in the model that disconnect domestic interest rates from domestic saving and investment?

b. What is determined by domestic saving and investment in the model?

Solutions

Expert Solution

a) the two simplifying assumptions in the model are the economy is small and there is perfect capital mobility. Because the economy is small it is not able to influence the economic variables of the world. Because there is perfect capital mobility domestic market participants whenever need to borrow a sum of money they will borrow at the world interest rate when the domestic interest rate is higher. Please ensure that domestic interest rate keeps in line with the world interest rate and both are equal.

b) domestic Savings and domestic investment together determine the rate of interest and the quantity of net exports in the economy. When the world interest rate is same as the domestic interest rate saving and investment both are equal to each other and there is trade balance. If in case there is a difference between the world interest rate and domestic interest rate there will be a deficit or a surplus in the trade

Rahul Sunny answered 1 year ago

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