Assume that the world works according to the Classical model. In a small open ec
ID: 1191764 • Letter: A
Question
Assume that the world works according to the Classical model. In a small open economy, output us produced according to the production function Y = AKa L(1-a), cosumption is equal to C = 50 + 0.8Yd, and the investment function is I = 400 - 2r. The public authorities of this country decide to implement a contractionary fiscal policy in the form of an increase in taxes T by $50.
a)What will happen in the domestic loanable funds market of this country after the increase in taxes is implemented? Will the domestic supply of loanable funds change? Will the domestic demand of loanable funds change?
b)What will happen to the trade balance of this country? If beofre the increase in taxes exports were larger than imports, will the country operate in a trade deficit, trade surplus, or balanced trade after the contractionary fiscal policy is implemented?
c) What will happen to the real exchange rate of this country after the increase in taxes is implemented? Will domestic goods become relatively cheaper or more expensive with respect to the goods produced in the rest of the world?
d) Assume that this country decides to forbid capital mobility and trade with rest of the world. In other words, this country decides to become a closed economy. How will the equilibrium real interest rate changes in this case?
Explanation / Answer
Y = C(Y - T) + I + G + X - M
(a)
When T increases, disposable income decreases and so, consumption decreases. Accordingly, savings also decreases.
Since savings is a supply of loanable funds, the supply of loanable funds will decrease. But demand for loanable funds is the investment component of aggregate demand, a tax hike will not affect I and so, demand for loanable funds will remain unchanged.
(b)
Ceteris Paribus, (S - I) = (X - M)
Since S > I [explained in part (a)], to maintain equilibrium, X > M.
Net exports increases. Since pre-tax increase trade balance was in surplus, after increased exports, trade surplus increases.
(c)
Since disposable income decreases due to tax hike, import demand will decrease, which will reduce the demand of foreign exchange which will depreciate vis-a-vis domestic currency, which will appreciate. So, real exchange rate will increase.
A domestic currency appreciation will make exports more expensive compared to rest of the world (which decreases export demand).
(d) If the economy becomes closed, its interest rate will be determined by domestic savings and investment only. But being a small economy, it cannot influence the world interets rate, and its domestic interest rate becomes irrelevant. Therefore, for such a country, world interest rate becomes its relevant interest rate, irrespective of the domestic interest rate.