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Most economists view a trade deficit not as a problem

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Unformatted text preview: interest as given, but its policies can have some effect on the risk premium. Foreign lenders demand a risk premium if they anticipate that the dollar my fall in value while the loan is outstanding. If that happens they will suffer a capital loss when they turn their earnings back into their own currency. To be compensated for that expected capital loss, lenders demand a yield greater than the world interest rate. For much of the discussion we abstract from issues of political uncertainty and set θ = 0. Thus, we assume that r = r*. The equilibrium of world saving and world investment determines the real interest rate. Our small open economy has a negligible effect on the world real interest rate because it is small and has a negligible effect on world saving and world investment. Page 13 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 Hence, our economy takes the world interest rate as an exogenously given variable. To build the model: NX = S – I = (Y – C – G) – I = [Y¯, – C(Y¯, – T) – G] – I(r*) = S¯, – I(r*) This equation shows that the trade balance NX depends on variables that determine S and I. Because saving depends on fiscal policy (T and G) and investment depends on the world real interest rate r*, the trade balance depends on these variables as well. The trade balance is determined by the difference between saving and investment at the world interest rate. How policies influence the trade balance, assuming we start off in a position of balanced trade and investment equals saving at the world interest rate: Fiscal policy at home: the government increases purchases. The increase in G reduces national saving, and with an unchanged world real interest rate, saving falls below investment. Since NX = S – I, the fall in S implies a fall in NX. The economy now runs a trade deficit. Say instead, the government decreases taxes. This reduces national saving. Since NX = S – I, NX falls. Fiscal policy abroad: consider what happens to our small open economy when foreign governments increase their government purchases. If these foreign countries are small, the impact is negligible. If these foreign countries are...
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