Question

Suppose the economy is initially in equilibrium. Congress passes a tax cut policy. Compare the impact of this policy in a small open economy and a large open economy.

1. In a small open economy, how does this policy affect national saving, the real interest rate, trade balance, and the real exchange rate? Use diagrams to help answer this question.
2. In a large open economy, how does this policy affect national saving, the real interest rate, trade balance, and the real exchange rate? Use diagrams to help answer this question.

Answer 1

Ans.

When taxes are cut it will make the investments to rise in the short run. This rise in investment will increase the savings(national savings).And this tax cut will be leading to trade deficits, the govt. revenue will decrease and demand for imports by the people will increase,So, there will be a increase in real exchange rate because of the increase interest rates.

When taxes are cut it will also make the investments to rise in the short run. When the economy is large, it will make the national savings to rise(increase) and also increase in trade balance. Here the real interest rate will grow or increase where as well the increase in exchange rate will happen.

In the long run, this interest rate increase will crowd our investment in different parts of the world as well. Which will result in trade to decline and world output will decrease .

In short run, everything will be same as metioned before.

The main difference between the two are that in case of large economy the spill over effect will be larger to the rest of the world.