How policies influence the real exchange rate fiscal

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Unformatted text preview: a large part of the world economy, their increase in G reduces world saving, causing the world interest rate to rise. This increases the cost of borrowing and thus reduces investment in our small open economy. NX = S – I, the reduction in I must increase NX, hence reduced saving abroad leads to a trade surplus at home. Shifts in investment demand: if, say, the government changes tax laws to encourage investment. The investment curve shifts outward, so at a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by borrowing from abroad; therefore since NX decreases it causes a trade deficit. The impact of economic policies on the trade balance can always be found by examining their impact on domestic saving and domestic investment. Policies that increase investment or decrease saving tend to cause a trade deficit, and policies that decrease investment or increase saving tend to cause a trade surplus. Most economists view a trade deficit not as a problem in itself, but perhaps a symptom of a problem. Trade deficits typically reflect a low saving rate, which leads to low investment and low capital stock. Yet trade deficits are not always a reflection of economic Page 14 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 malady, such as when poor rural economies develop into modern industrial economies. They sometimes finance nment reduces national saving by increasing G or decreasing T, the (S – I) line shifts left, lowering the supply of Canadian dollars to be invested abroad. This causes the equilibrium real exchange rate to rise (the dollars becomes more valuable) and since the exchange rate has risen and domestic goods become relatively more expensive, NX falls. Fiscal policy abroad: if foreign governments increase G or lower T, this reduces world saving and raises the world interest rate. The increase in the world interest rate reduces domestic investment, which shifts (S – I) right and thus increases NX while lowering the exchange rate. Shifts in investment demand: if the government introduces an investment tax credit for example, at a given world interest rate, the increase in investment demand leads to high investment. Higher I means lower (S...
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This test prep was uploaded on 03/28/2014 for the course ECON 2000 taught by Professor Henriques during the Fall '10 term at York University.

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