Consider savings and investment in a small, open economy model. Suppose the exogenous world interest rate...

Consider savings and investment in a small, open economy model. Suppose the exogenous world interest rate determines the investment.

a) Draw the demand and the supply of loanable funds. What determines the net exports, NX (or net capital outflow) in this open economy?

b) Show the impact of a fiscal policy change at home (an increase in G or a decrease in taxes) on savings, investment and net export (NX) with the help of a graph in this model.

c) Use the model to determine the impact of an increase in investment demand on savings, investment and net export (NX) with the help of a graph in this model

Solutions

Expert Solution

(a)

In the graph, panel A shows demand curve (investment) and supply curves (savings) for loanable funds. D0 and S0 are initial demand and supply curves intersecting at point A with initial real interest rate r0 and initial quantity of loanable funds Q0.

Panel B shows net capital outflow as an inverse function of interest rate.

Panel C shows net exports (NX) as an inverse function of exchange rate.

So, NX is determined by the demand and supply of loanable funds which determine the interest rate.

(b)

The expansionary fiscal policy increases demand for loanable funds due to budget deficit financing. D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds (savings and investment) Q1.

In panel B, higher interest rate from r0 to r1 decreases net capital outflow from NCO0 to NC01.

In panel C, decrease in NCO decreases net exports from NX0 to NX1, increasing exchange rate from e0 to e1.

(c)

An increase in investment, which is the demand for loanable funds, will increase the demand for loanable funds. As in above part (b), D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds (savings and investment) Q1.

In panel B, higher interest rate from r0 to r1 decreases net capital outflow from NCO0 to NC01.

In panel C, decrease in NCO decreases net exports from NX0 to NX1, increasing exchange rate from e0 to e1.

Rahul Sunny answered 2 years ago

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