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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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