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Homework answers / question archive / Problem set on model of small open economy in the long run Suppose Canada can be described by our model of a small open economy in the long run
Problem set on model of small open economy in the long run Suppose Canada can be described by our model of a small open economy in the long run. Depict each event listed below on two graphs. On the left-hand side graph, show what happens to Canada's national saving and investment. On the right-hand side graph, show what happens to Canada's real exchange rate. For each event, assume everything I did not mention remains fixed. Label the "before" lines or variables with a subscript"0" (e.g. X, ). Label the "after" lines or variables with a subscript "1" (e.g. X, ). State whether Canadian net exports increase, decrease, or don't change. State whether the Canadian real exchange rate increases, decreases, or doesn't change. Assume that before each event, NX=0.
1) There is an increase in the world real interest rate r*
2) There is an increase in Canadian government spending on goods and services, with no change in Canadian taxes.
3) A useful new kind of capital equipment becomes available in Canada, so that Canadian firms would want to engage in more investment spending at any given real interest rate.
4) Foreign demand for Canadian products increases, so that Canadian exports would be greater at any given real exchange rate.
Answer:
The model for a Small Open economy can be written as,
Y = C(Y - T) - I(r) - G + Ex - Im
where, Ex = Export and Im = Import
So, we have
NX = Y - [C(Y - T) - I(r) - G]
NX = Y - C(Y - T) - G - I(r), where Y - C(Y - T) - G = National Savings (S), and I(r) = Investment (I)
r* = World Real Interest Rate
Thus, we can write,
I = I(r) = I(r*)
Thus, we have a Straight Vertical National Savings = Y - C(Y - T) - G
and an inverse Investment curve = I(r), I'(r) < 0
Small economy is too small for World Interest Rate to affect investment, and Canada accepts r*.
However, this situation is different for an Open Economy.
Now, consider a Open Economy
NX = Y - C(Y - T) - G - I(r) = Y - C(Y - T) - G - I(r*) = S - I
Thus, NX = S - I
Such that, if r* > r, S > I, and NX > 0, which indicates a Positive Trade Deficit, (where there is substantial effect of r* on Investment.)
Also, Real Exchange Rate is Negatively related to Net Exports.
Consider the Diagrams below, based on the situation given in the question.
PFA
