Question

Suppose that we are in a small open economy as modelled in Chapter 6 in Mankiw. Now suppose that the government increases taxes (T) and government purchases (G) by equal amount. What happens to the interest rate (r), investment (I), trade balance (NX) and real exchange rate (ε) in response to this balanced-budget change?

Answer 1

The government spending multiplier is higher than absolute value of the tax multiplier. Hence, when Tax (T) and Government spending (G) increases by same the amount, even though budget balance stays the same, the net effect of equal increase in G and T is an increase in output and income. Higher income increases consumption and savings. This shifts the National Savings curve rightward. Interest rate decreases and quantity of saving and investment increases.

As interest rate decreases, net capital outflow increases, increasing net exports (trade balance) and decreasing real exchange rate.

In following graph, panel A reflects the National saving (S) and investment (I) curves. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

When savings increase, S0 shifts right to S1, intersecting I0 at point B with lower interest rate r1 and higher quantity of saving and investment Q1.

In panel B, reflecting net capital outflow as negative function of interest rate, lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C, reflecting net exports as negative function of exchange rate, an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1.