Question

1. In times of great economic uncertainty and potential job loss like this Pandemic, many consumers may increase their saving as a precautionary measure. What is the predicted impact of an increase in national saving on the domestic interest rate and exchange rate in a large open economy, holding other factors constant? Illustrate your answer graphically and explain in words in details.

Answer 1

Given the pandemic situation, many consumers may increase their savings as a precautionary measure, which will result in a decrease in the consumers' consumption spending. As a result, the IS curve shifts leftward, as shown in the graph:

The leftward shift in the IS curve decreases the country's domestic interest rate and income/output. Decreased domestic interest encourages people to invest outside the country that results in an increase in the capital outflow. An increase in capital outflow increases the supply of domestic currency in the global economy. As a result, the exchange rate decreases in a large open economy.