Question

UK is small open economy with a flexible exchange rate regime and perfect capital mobility.
Suppose that the consumption function shifts down, due perhaps to a worsening of consumer confidence. That is, for every level of disposable income, consumers want to consume less. Explain the direction of the effect of this change on output, consumption, investment, interest rate, net exports and exchange rate.

Answer 1

Let the economy is in equilibrium at A, where IS = LM, where interest rate = i1 and output = Y1

Small open economy means it will not impact the foreign interest rate.

Perfect capital mobility implies that the BP curve will be horizontal line passing through the A.

As consumer now wants to consume less at every level of disposable income => IS curve will shift leftward => economy now move to point B.

=> A decrease in the interest rate to i2 and output will decrease to Y2

Since, domestic interest reduces it will not affect the world interest rate due to small economy => foreign interest rate will be attractive now for the investors. Hence there will be capital outflow(KO).

=> hence, there will be increase in capital account deficit. => BOP deficit

Since the domestic interest rate decreases, from the interest parity condition now exchange rate will increase & since there is a flexible exchange rate hence the domestic currency will depreciate.

=> Since BOP should be 0 but due to capital outflow there is capital account deficit. Hence to make BOP = 0, there should be current account surplus & since the currency depreciates, price of exports will reduce. combining these two now exports (X) will rise.

=> since IS :-- Y = C + I + G + NX(X - M) . hence a rise in exports will lead to rise in the output

=> hence again the IS will shift and will go back to the initial position.

=> hence again economy will move back to initial position to A.

=> Hence interest rate and output restored at the initial level.

Only net exports will rise due to rise in exports

& exchange rate will increases.