Question

(a) Over the past decade, some of Japanese savings has been used to purchase large amounts of U.S. financial assets (typically U.S. government bonds). Suppose Japan suddenly stopped purchasing U.S. financial assets. Graphically illustrate the effect of Japan’s reduction in purchases of U.S. financial assets using the Open Economy model developed in the Ch 6 appendix. (Hint: In your model you will need to draw three diagrams). Clearly label the axes and curves in each of your graphs in the model. Clearly indicate the direction of any shifting curves. In your model, label the initial equilibrium points as Point A and label the new equilibrium points as Point B. Using your model drawn in Part (a), indicate what effect the reduction in Japanese investment in U.S. financial assets will have on the following economic variables in the United States: (i) real interest rate, (ii) domestic investment, (iii) net capital outflow, (iv) real exchange rate, (v) net exports.  

Answer 1

In following graph, panel A shows national saving (S) and investment (I) curves for the US, with interest rate (r) and saving/investment (Q) being measured along vertical and horizontal axes, respectively. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

Panel B shows net capital outflow (NCO) as inverse function of interest rate (r). Point C represents the initial point corresponding to point A in panel A.

Panel C shows net exports (NX) as inverse function of exchange rate (e). Point E represents the initial point corresponding to point C in panel B.

Lower Japanese purchase of US securities will decrease US national savings. The savings curve shifts leftward, increasing interest rate and decreasing equilibrium saving and investment.

As interest rate increases, net capital outflow decreases, which in turn decreases net exports and thus, increases exchange rate.

In panel A, As national savings decrease, S0 shifts left to S1, intersecting I0 at point B with higher interest rate r1 and lower quantity of saving and investment Q1.

In panel B, higher interest rate from r0 to r1 (at point D) decreases net capital outflow from NCO0 to NC01.

In panel C, a decrease in net capital outflow from NCO0 to NCO1 decreases net exports from NX0 to NX1 and increases exchange rate from e0 to e1 (at point F).