Question

Wealth falls in a small open economy with initial current account equal to zero (CA = 0). Determine the impact of the decline in wealth on the expected real rate of interest, the level of savings, the level of investment, the current account and capital financial account. You must provide a graph in your answer to receive full credit.

Answer 1

The impact of decline on the above mentioned variables is depicted in the three panelled diagram above. The intial equilibrium in the loanable funds market occurs at point E1. A decrease in the expected real wealth of the individuals will decrease the level of private savings in the economy and thus supply of loanable funds will decrease in the economy and the supply curve will shift leftwards to Slf' and new equilibrium will occur at point E2 where the real rate of interest has increased in the loanable funds market. This reduces the level of private investment in the loanable funds market.

This increase in the rate of interest will cause an upward movement on the Net capital outflow in the economy which will lead to decrease in Net capital outflow in the economy to NCO₂. In the foreign exchange market, this will shift the supply curve of the currency leftwards to S' and thus increases the value of exchange rate which leads to appreciation of domestic currency.

Thus, appreciation of currency will reduce Net exports of the nation and this will reduce current account balance of the nation. Net capital inflow and decline in outflow will improve the capital financial account of the economy.