Question

In this problem, you are asked to draw graphs. Please use a straight edge and draw them as neatly as possible. Imagine the world relative to a small open economy. Draw three graphs in order to illustrate the initial conditions in the problem. The first graph represents the world’s loanable funds market. Illustrate the initial supply of loanable funds (Saving), initial demand for loanable funds (investment), and the initial equilibrium world interest rate (r*). Properly label the axes. Remember that the entire world is a closed economy. The second graph represents the small open economy’s loanable funds market (similar to Figure 6-2 in your textbook). Properly label the axes. Assume that initially r* < r. What does this assumption imply about net capital outflow and the trade balance in the small open economy? Explain your answer. Properly illustrate the implication on your graph. The third graph represents the small open economy’s exchange rate market (similar to Figure 6-8 in your textbook.) Properly label the axes and annotate an initial equilibrium real exchange rate.

Now we will shock our markets. Assume that the rest of the world inexplicably experiences an increase in investment demand, but the small open economy does not. What happens to the world real interest rate and to saving, investment, the trade balance, and the exchange rate in the small open economy? Please reproduce your first three graphs and illustrate the impact in each of the three graphs. Make sure you also explain precisely why particular variables are changing.

Answer 1

Hi  

The answer of the following question is given below as follows :

Now ans. B as follows.

Note : Now the net capital outflow will rise because of the fact that now investors are selling and buying the assests.

I hope I have served the purpose well.

Thanks.