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Assume that Indonesia is a small open economy. Explain how a decrease in the level of...

Assume that Indonesia is a small open economy. Explain how a decrease in the level of taxes in the rest of the world (T∗) affects the world interest rate, the Indonesian interest rate, level of investment, net exports and net capital outflows in Indonesia. Support your answer with a graph of the rest of the world loanable funds market and a graph of the Indonesian loanable funds market.

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Answer #1

Decreasing tax rates lead to increase in interest rates. The reason is, people are left with more disposable income.They start to spend more and demand for money increases and hence interest rates go up. Demand for loanable funds will shift to right and hence interest rates in the world will go up from i1 to i2. Refer fig. a

Due to increasing demand for Indonesian goods, aggregate demand in Indonesia will shift to right and its currency will appreciate, terms of trade will improve due to more exports in the short term, currency rate will go up as demand for currency goes up.

Capital outflows from Indonesia will be more as world is offering more interest rates now. Hence loanable funds supply from Indonesia will shift to right and interest rates will go down. Refer fig. b this effect however depends on demand for money.

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