Question

A large and persistent external deficit often leads to calls for policy measures such as bilateral trade negotiations, tariffs and important quotas, directed at restoring balance between exports and imports. However, current account deficits ultimately reflect a disparity between savings and investment; fundamental national income accounting identities ensure that the current account is equal not only to the difference between exports and imports, broadly defined, but also to the difference between savings and investment (Krugman 1991).

Therefore, the issue of how current account balance is achieved in practice can be viewed in terms of whether it is savings or investment that adjusts to an external imbalance. To the extent that a country that borrows from abroad does not default on its debt obligations, high current account deficits must eventually be followed by higher national savings or lower investment. In a series of influential articles, Feldstein (1992), argued that while, in the short run, inflows of foreign capital can offset the difference between national investment and national savings, in the long run, the rebalancing of the current account occurs mainly through changes in investment. This is because the country’s saving rate is, in the long run, predetermined by the household's attitudes toward savings and borrowing, by the fiscal incentives for private savings, and by the public attitude toward budget deficit.

As such, a country’s savings rate ultimately constrains the rate of investment; low levels of national savings lead, in the long run, to low levels of investment, with potentially important implications for a country's future standard of living. Feldstein’s preferred policy conclusion is that government measures aimed at raising a country’s savings rate will generate an almost one-for-one increase in its long-run investment rate.

While their ability of government to permanently raise a country’s savings rate remains highly controversial, it is still the case that solvency implies the permanent changes in savings or investment must lead to changes in the other variable of approximately the same amount.

That's all info and they ask:

How interest rate will change in response to A2 shock?

Answer 1

First of all, it should be noted that any change in savings or investment must be trailed by future movements in savings and investment that is equivalent to the first change in present worth. In the event that the change is perpetual, the best way to keep up solvency is to alter the other variable as needed. In this manner, the degree to which the first change in savings (investment) perseveres after some time directs what division of the acclimation to an outer irregularity is borne by investment (savings).

The response of interest rates to shocks results in decreased consumption growth for the country because the central banks are constrained by the zero lower bound. The Federal Reserve effectively kept up a functioning financial strategy despite the zero lower bound.

It ought to be noticed that only country-specific productivity shocks should apply a sizable effect on the current account. The explanation is that if an increase in productivity is generalized to all the countries, then all consumers will simultaneously try to dis-save. At the point when this isn't the situation, a worldwide productivity shock will influence every nation's current account. In any case, the outcome that nation-specific shocksought to largerly affect the current account than global shocks still remains constant because the world real interest rate in such a way as to reestablish balance between national savings and investment.