Question

In a small open economy, starting from a position in which net exports are equal to zero (i.e., balanced trade), if the government increases government expenditure, this produces a tendency toward a trade ......…..and ...........net capital outflow.

Answer 1

At equilibrium Y = C + I + G + NX ----------------------(1)

Private saving = Y - C - T and Public saving = T - G

where C = consumption, Y = income, I = Investment , NX = Net exports and T = Taxes

National saving(S) = Private saving + public saving = Y - C - T + T - G = Y - C - G

Putting this in (1) we get : Y - C - G = I + NX => S = I + NX => NX = S - I

If government increases government expenditure i.e. G increases then S(=Y - C - G) decreases.

Initially, Net exports = 0 i.e. S = I Now S decreases thus now we have S < I => NX = S - I < 0.

Hence, Net exports will be negative implies there will be a trade deficit.

Thus If NX < 0 then Net capital outflow is negative and if NX > 0 then Net capital outflow is positive and. Hre NX < 0 => There will be a negative trade deficit.

Hence ,

In a small open economy, starting from a position in which net exports are equal to zero (i.e., balanced trade), if the government increases government expenditure, this produces a tendency toward a trade deficit and negative net capital outflow.