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If a war broke out abroad, it would affect the U.S. economy in many ways. Use...

If a war broke out abroad, it would affect the U.S. economy in many ways.

Use the model of Small Closed and Small open economy to examine each of the following effects of such a war.

What happens to savings, investment, the trade balance, the interest rate, and the exchange rate? (To keep things simple, consider each of the following effects separately.)

a) The U.S. government, fearing it may need to enter the war, increases its purchases of military equipment.

b) Other countries raise their demand for high-tech weapons, a major export of the US.

c) The war makes US firms uncertain about the future, and the firms delay some investment projects.

d) The war makes US consumers uncertain about the future, and the consumers save more in response.

e) Americans become apprehensive about traveling abroad, so more of them spend their vacations in the US.

f) Foreign investors seek a safe haven for their portfolios in the University States

Solutions

Expert Solution

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Question:

Answer:

Close Economy: A close economy is the economy which is closed for the outsider world. This economy does not trade with the other economy/countries. It is self dependent and capable to fulfill the domestic demand.

Open Economy: It is a type of economy that is totally opposite of closed economy. Open economy is an economy where goods and services are traded with other countries without rules or limits.

As per the question we have to use the model of Small Closed and Small open economy to examine each of the following effects of such a war. What happens in the US to savings, investment, the trade balance, the interest rate, and the exchange rate? (To keep things simple, consider each of the following effects separately.)

a) The U.S. government, fearing it may need to enter the war, increases its purchases of military equipment.

In case of close economy its not possible because its self sufficient but in case of a small open economy it will increase import and negatively affect the trade balance and increasing supply of dollar (because of military equipment's import) its will depreciate USD. Current Account = Savings – Investment. Other side a decrease in savings means people are spending more therefore, this would tend to suck in imports as we buy goods and services from abroad and export is lower than import. Here increasing expenses will decrease saving and increasing export will decrease AD that will decrease GDP that will decrease income level that will also negatively affect the saving. Increasing spending will negatively affect the budget deficit and increase government's borrowing that will increase interest rate.

b) Other countries raise their demand for high-tech weapons, a major export of the US.

In case of close economy its not possible because its self sufficient and there is no any trade activity with other countries. In the case of open economy it will increase export that will increase net export and AD that will increase GDP and income level. Increasing income will increase saving and investment and increase demand for USD and USD will get appreciated. It will positively affect the trade balance and increase money supply in the economy and interest rate will decrease.

c) The war makes US firms uncertain about the future, and the firms delay some investment projects.

In case of close economy its not possible because its self sufficient and there is no any trade activity with other countries. In the case of open economy it will decrease AD that will decrease GDP and price level and decrease demand for money that will decrease interest rate and USD will appreciate. Other side decreasing income level will decrease saving and investment. Delay in investment project will increase project cost and negatively affect the supply side that will negatively affect the export and trade balance but it will depend upon the nature of project. But other side depreciating currency will help in increasing export that will be a healthy sign for the net export or trade balance

d) The war makes US consumers uncertain about the future, and the consumers save more in response.

In case of close economy its not possible because its self sufficient and there is no any trade activity with other countries. In the case of open economy it will decrease AD that will decrease GDP and price level and decrease demand for money that will decrease interest rate and USD will appreciate. Other side decreasing income level will decrease saving and investment. Here currency will depreciate and trade balance will improve.

e) Americans become apprehensive about traveling abroad, so more of them spend their vacations in the US.

In case of close economy its not possible because its self sufficient and there is no any trade activity with other countries. In the case of open economy it will decrease their spending that will increase saving and investment. Other side it will increase domestic demand and it will increase demand for USD and USD will appreciate and it will also increase price level. Increasing price level and domestic demand can increase inflation and interest rate could be increase. Other side It will also supportive for the trade balance but appreciating USD can decrease Export that could be negatively affect the trade balance.

f) Foreign investors seek a safe haven for their portfolios in the University States.

In case of close economy its not possible because its self sufficient and there is no any trade activity with other countries. In the case of open economy it will increase demand for the USD and USD get appreciate. It will increase monetary base and money supply that will decrease interest rate. It will increase AD that will positively affect the income level that increase saving and investment. It will increase price level (inflation) and USD get depreciated and export will increase and trade balance will improve.

Thank You


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