Practice Exam 1- Spring 2012

Graphically this is represented as a leftward shift in

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Unformatted text preview: he Pacific Ocean. Originally, this economy is isolated from the rest of the world (i.e., a closed economy). Suppose that the equilibrium real interest rate in this economy is higher than the world real interest rate. Carefully analyze and explain what will happen to this economy, once this country opens up to the rest of the world. Be specific to changes in national saving, domestic interest rate, investment, and net exports. Once the country opens up to the rest of the world, investors in other countries will find very attractive to invest in this small island economy and capital inflow continues until the domestic interest rate equals to the world interest rate. In the closed economy, the economy stays at A, where Sclosed = Iclosed. In the equilibrium for the small open economy at B, this is no longer the case. With the lower world interest rate (r* < rclosed), the domestic investment is encouraged more (Iopen > Iclosed). Since domestic factors (e.g., Y, T, G) are not changed, national saving stays the same. As a result, NX = Sopen – Iopen < 0. r rclosed Sclosed (= Sopen) A B r* World interest rate I(r) Iclosed I(r*) NX = Sopen – Iopen < 0 II. S, I [10 pts] Consider the general money demand function (M/P)d = L(i, Y), where (M/P)d is the real money balances demanded, i is the nominal in...
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