SUPPOSE THAT SOME FOREIGN COUNTRIES BEGIN TO SUBSIDIZE INVESTMENT BY INSTITUTING AN INVESTMENT TAX CREDIT.

A. WHAT HAPPENS TO WORLD INVESTMENT DEMAND AS A FUNCTION OF THE WORLD INTEREST RATE? If the countries that institute an investment

tax credit are large enough to shift the world investment demand schedule, then the tax credits shift the world investment demand schedule upward.

B. WHAT HAPPENS TO THE WORLD INTEREST RATE? The world interest rate increases from r to r

because of the increase in world investment demand.

C. WHAT HAPPENS TO INVESTMENT IN OUR SMALL OPEN ECONOMY? The increase in the world interest rate

increases the required rate of return on investments in our country. Because the investment schedule slopes downward, we know that a higher world interest rate means lower investment.

D. WHAT HAPPENS TO OUR TRADE BALANCE?

Given that our saving has not changed, the higher world interest rate means that our trade balance increases.

E. WHAT HAPPENS TO OUR REAL EXCHANGE RATE? To bring about the required increase in the

trade balance, the real exchange rate must fall. Our goods become less expensive relative to foreign goods, so that exports increase and imports decrease.

QUESTION 2 Y C I G NX, Y 5,000, G 1,000, T 1,000, C 250 0.75(YT ), I 1,000 50r, NX 500 500e, r r* 5.

A. IN THIS ECONOMY, SOLVE FOR NATIONAL SAVING, INVESTMENT, THE TRADE BALANCE, AND THE EQUILIBRIUM EXCHANGE RATE. National saving is the amount of output that is not purchased for current

consumption by households or the government. We know output and government spending, and the consumption function allows us to solve for consumption. Hence, national saving is given by:

S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750. Investment depends negatively on the interest rate, which equals the

world rate r* of 5. Thus, I = 1,000 – 50 × 5 = 750. Net exports equals the difference between saving and investment. Thus, NX = S – I = 750 – 750 = 0. Having solved for net exports, we can now find the exchange rate that

clears the foreign-exchange market: NX = 500 – 500 × ε 0 = 500 – 500 × ε ε = 1.

B. SUPPOSE NOW THAT G RISES TO 1,250. SOLVE FOR NATIONAL SAVING, INVESTMENT, THE TRADE BALANCE, AND THE EQUILIBRIUM EXCHANGE RATE. EXPLAIN WHAT YOU FIND.

S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250 = 500 I = 1,000 – 50 × 5 = 750 NX = S – I = 500 – 750 = –250 NX = 500 – 500 × ε –250 = 500 – 500 × ε ε = 1.5. The increase in government spending reduces national saving,

but with an unchanged world real interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciate.

C. NOW SUPPOSE THAT THE WORLD INTEREST RATE RISES FROM 5 TO 10 PERCENT. (G IS AGAIN 1,000.) S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750 I = 1,000 – 50 × 10 = 500 NX = S – I = 750 – 500 = 250 NX = 500 – 500 × ε 250 = 500 – 500 × ε ε = 0.5. Saving is unchanged from part (a), but the higher

world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, which requires that the currency depreciate.