Question

Consider a large open economy that has a zero-current account balance. What are the effects on the world real interest rate, national saving, investment, and the current account in equilibrium if:

(a) future income rises?

(b) business taxes decline?

Explain using graphs.

Answer 1

The current account is an important indicator to show the growth of an economy. It is the sum of Balance of trade(Export-Import), Net factor income from abroad and net current transfers.

When all the components of balance of payment are included they must sum to zero with overall surplus or deficit. Here the large open economy is in a situation of zero current account balance. It will effect the world real interest rate, national saving, investment and the current account in equilibrium.

Now we are given few situations and we need to know how they are effected by it.

a) If the future income rises then:-

-The world real interest rate will rise. The real interest rate is the growth in real value of the loan plus interest, taking inflation into it. If future income rises the re interest rate too will rise.

-The national saving will fall. It will lead to fall in the government savings. Basically, its the total of private as well as public savings. In mathematical form, Consumption - Investment.

-The investment will also fall. The money invested will fall due to rise in incomes.

-The current account will also fall. Current Account is directly connected to the balance of payment of a nation. The rise in income will ultimately lead to fall in current account.

b) If business taxes decline then

-The world real interest rate will rise. If the business taxes will declines there would be less of real interest rate and it will ultimately fall. The real income depends on the production and gains from the trade.

- The national saving will rise. The Business taxes are very sensitive to an economy. They plays a significant role. It ultimately leads to collapse of business revenues. So, of the business taxes decline the savings of the government will rise.

- The investment too will rise. Same as discussed above. the investment will increase if the business taxes reduces.

- The current account will fall. The current account is directly linked to Country's economy. They too are very sensitive to an economy. If the business taxes decline the current account will ultimately fall.

Here, below is the graph to elaborate and prove my answer. The graph depicts the balance of zero current account for both sectors. However, there are few conditions for zero current account. Few of them are:-

Job opportunities in export.

Higher amount of exports.

Accumulation of foreign goods.