Unformatted text preview: .LJL/lV lUl - ldll LUlU— lVllUlCllll 11‘4" Ul. l‘lCllkCl Question Number Two The Small Open Economy, Chapter #5. The small open economy faces an interest rate that is determined in the global financial markets.
This rate, r‘, is exogenous as far as the domestic small open economy is concerned. It is global savings and global investment that determines the rate of interest, not the level of savings and
investment in the domestic economy. In Chapter #5, we examined the small open economy using two basic graphs. The first graph
describes the relationship between domestic savings and investment with respect to the global
interest rate, r‘. The second graph describes the results of the first graph (a trade balance, surplus or deficit) as a relationship between net exports (X — M) and the real exchange rate. Using these two graphs please show what happens first to domestic S, I, net exports (X — M), and
the net foreign investment position (NFI or net capital in/outﬂow), AND then to the relationship
between net exports and the real exchange rate when the following occurs. Hint: Start your answer with your economy in an equilibrium where “S — I = 0” (hence
(X — M = 0). USE A FEW WORDS TO DESCRIBE WHAT IS LOGICALLY ' HAPPENING IN YOUR GRAPHS. Carefully label your graphs’ axes and the curves as well.
(1) There is a tax increase in the domestic (small open) economy. (5 points possible) (2) The domestic (small open) economy ﬁghts a war and DOMESTIC government spending
goes up! How does the government finance this spending increase? (10 points possible) (3) A surge of business optimism in the domestic economy results in a rise in the level of demand
for investment. (The investment demand function rises in the domestic economy.) (10 points
possible) (4) There is a sudden rise in government spending throughout the rest of the world (not in the
domestic economy). (10 points possible) ...
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- Fall '08