Question

Use the model of the small open economy (need to show the graphs) to predict what would happen to the trade balance, the real exchange rate and the nominal exchange rate in response to each of the following:

• A tax reform increases the incentive for businesses to build new factories

• The introduction of a stylish new line of Toyotas makes some consumers prefer foreign cars over domestic car

Answer 1

The tax reform will act as a catalyst to increase the investmentin the economy, more would be demanded at the given price and hencethe domestic price would go up. Because of domestic investment on arise, there would be fewer imports (Less currency available tobuy/invest), hence increase in real exchange rate. This would makethe domestic goods expensive as compared to the foreign goods andthe exports would fall with a rise in imports, worsening the tradebalance. The nominal exchange rate would rise because there hasbeen no change in the price level. (shifts the IS curve toleft).