Question

Answer the following Intermediate Macroeconomics questions:

a) Suppose that the large open economy conducts a contractionary fiscal policy (i.e., raising taxes and decreasing government spending), illustrate graphically how the small open economy would be impacted. In your graphs, labeled all your graphs correctly and all terminal equilibrium points and values.

b) Based on your graphical analysis, explain briefly what happens to the small open economy net exports, investments, national savings.

Answer 1

a) contractionary fiscal policy decreases aggregate demand in open economy that results in decrease in total income. Decrease in income leads to decrease in total imports from other countries. This implies decrease in exports of small economy to large economy. As a result aggregate demand also decreases in small economy that results in decrease in real gdp.

b) in small economy net exports decrease. Decrease in aggregate spending also results in decrease in interest rate that increases investment spending. National savings depen on real gdp and decrease in real gdp leads to decrease in national savings.