Question

Consider a large open economy. Imagine that initially the economy is bor- rowing from the rest of the word. Explain what happens in each of the following scenarios.

1. What do you expect to happen to the magnitude of domestic borrowing when foreign governments impose restrictions on capital mobility and prevent foreign residents from investing at will in the domestic economy?

2. Imagine that domestic rating agencies start to credibly rate foreign assets. How does this impact the world interest rate?

Answer 1

The open economy refers to the business transanctions between all the traders of the domestic country with other traders outside the countries. The open economy with the international transanctions urges the borrowing of the money from the sources outside the country. In order to increase the quantity of goods and services in the economy, there is a chance of borrowing from outside sources beyond the boundary of the country. In the domestic market consumer has many choices of buying goods and services. If the demand of the goods increases in the domestic market, need for more goods will increase. This in turn makes the fine environment of more borrowings from outside the country. With the context of above explained facts, let us discuss the two scenarios.

1. The capital mobility has its own negative effects in which the value of the currency exchange reserves faces the uncertain decrease. This will make the country to impose restrictions on other foriegn investments in its domestic economy. It is true fact that when developed countries invests in any domestic capital market of the developing countries, the wage rate increases with the proportional rate. When the developing country impose foreign investments, it drastically effects the internal economic conditions by the way of poor wage rate, fall in employment level and less production of goods and services. With good source of capital mobility foreign investments with high exchange rate of currency value has the capaibility of good economic conditions. But when the country suddenly faces the problem of devaluatioin of the currency nor increase in trade deficit restricts the other foreign developed economy to invest in its own domestic market.

2. Domestic rating agencies are the companies which rate the ability of paying debts thorough treasury bonds of all the government. It includes all the bonds of mortage backed securities. If domestic agencies rates the foreign assents amidst the level of currency value at present situation. This will create one opportunity of all the countries to invest in the open economy. This will increase the free borrowings and rate of interest for the cheap borrowing will increase. Tariff on exports and imports will be minimal in order to smooth flow of sale of goods and services.