3 The following is a savinginvestment diagram for a small op

3.   The following is a saving-investment diagram for a small open economy:

a) If we know currently that S > I in the small open economy, the world real interest rate is indicated by

__________, net exports (NX) will be in __________, and is measured in the diagram by the distance (D-E, F-G, etc.)

__________. The small open economy can also expect its net international capital flow to be an ___________ .

b) Suppose now there is a decrease in government budget deficits. This will cause a ___________ of the

__________ curve. World real interest rate is expected to __________, Investment is expected to __________, and the original Net exports surplus or deficit (NX) will become __________.

Real Interest Rate, r (percent) Saving Curve Investment Curve DE F G H Desired Saving and Investment (in billions of dollars)

Solution

If S>I it means that the interest rate for the small open economy is higher than the equilibrium interest rate and for the small open economy, the domestic interest rate is equal to the world interest rate. Hence the world interest rate is shown by A. We also know from the basic macroeconomic identity that S-I=NX. Since here S>I so net exports is positive and so net exports will be in surplus and is indicated by the distance G-E.

The small open economy can also expect its net international capital flow to be negative or in deficit because the excess saving in the SOE is used to finance imvestments abroad.

(b)

Suppose now there is a decrease in government budget deficits. This will cause a rightward shift of the savings curve because government saving has increased. World real interest rate is expected to remain the same since SOE cannot affect the world rates and so Investment is expected to remain the same, and the original Net exports surplus (NX) will become large because S has increased.