17) In a small open economy, Sd = 200 + 500rw and Id = 300 – 200rw. If rw = 0.1, then net
exports =
A) -50.
B) -30.
C) 30.
D) 50.
18) What determines the interest rate in a small open economy?
19) In a small open economy,
Sd = $5 billion + ($100 billion) rw,
Id = $10 billion – ($50 billion) rw,
Y = $50 billion,
G = $3 billion,
rw = .06.
(a) Calculate the current account balance.
(b) Calculate net exports.
(c) Calculate desired consumption.
(d) Calculate absorption.
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20) Consider a small open economy with desired national saving of Sd = 20 + 200rw and desired
investment of Id = 30 – 200rw.
Calculate national saving, investment, and the current account balance in equilibrium when the
real world interest rate is
(a) rw = 0.025.
(b) rw = 0.05.
(c) rw = 0.0.
(d) Now suppose something causes desired national saving to increase by 10, so that it is now Sd
= 30 + 200rw. Repeat parts (a), (b), and (c).
(e) Suppose, with desired national saving at its original level of Sd = 20 + 200rw, something
causes desired investment to rise by 10, to Id = 40 – 200rw. Repeat parts (a), (b), and (c).
21) Consider a small open economy with desired national saving of Sd = 1000 + 1000rw and
desired investment of Id = 1000 – 500rw.
Calculate national saving, investment, and the current account balance in equilibrium when the
real world interest rate is
(a) rw = 0.025.
(b) rw = 0.05.
(c) rw = 0.0.
22) In a small open economy, describe what happens when an increase in wealth causes national
saving to decline. Explain the impact on the real interest rate, saving, investment, net exports,
and absorption in equilibrium.
23) Consider a small open economy in equilibrium with a zero current account balance. What
happens to national saving, investment, and the current account balance in equilibrium if
(a) future income rises?
(b) business taxes rise?
(c) government expenditures decline temporarily?
(d) the future marginal product of capital rises?
24) Consider a small open economy in equilibrium. What happens to the real interest rate,
national saving, investment, and the current account balance in equilibrium in each of the
following situations (each taken separately). Explain which curve shifts and why, and show a
diagram explaining your results. (You may assume that none of the shocks is large enough to
significantly affect labor supply or labor demand significantly.)
(a) wealth declines
(b) business taxes decline
(c) income rises temporarily
25) Consider a small open economy that is in equilibrium with a current account surplus.
(a) Draw a diagram showing this situation.
(b) Now suppose that future income increases. Show what happens in your diagram. What
happens to the world real interest rate and the equilibrium quantities of saving, investment, and
the current account balance?
(c) Repeat parts (a) and (b) for the case of a large open economy, showing a situation in which
the home country initially has a current account surplus. Draw a diagram and describe how the
rise in future income in the home country affects all four variables (the world real interest rate
and the equilibrium quantities of saving, investment, and the current account balance) in both
countries.
26) Consider a small open economy in equilibrium with a current account deficit.
(a) Draw a diagram showing this situation.
(b) What happens to national saving, investment, and the current account balance in equilibrium
if government expenditures rise temporarily? Show this result in your diagram.
5.4 Saving and Investment in Large Open Economies
1) A large open economy
A) dominates world trade in one or more products.
B) is physically larger than all small open economies.
C) has a larger population than all small open economies.
D) lends or borrows enough in the international capital market to influence the world real interest
rate.
2) When there are two large open economies, the world real interest rate will be such that
A) desired international lending by one country equals desired international borrowing by the
other country.
B) desired international lending will be the same in both countries.
C) desired international borrowing will be the same in both countries.
D) desired international lending and borrowing will be zero in both countries.
3) When there are two large open economies, if desired international lending by the domestic
country exceeds desired international borrowing by the foreign country, then
A) domestic saving must rise.
B) domestic saving must fall.
C) the world real interest rate must fall.
D) the world real interest rate must rise.
4) When there are two large open economies, if desired international borrowing by the domestic
country exceeds desired international lending by the foreign country, then
A) domestic investment must fall.
B) domestic investment must rise.
C) the world real interest rate must fall.
D) the world real interest rate must rise.
5) A large open economy reduces its investment demand. This causes the world real interest rate
to ________ and the country’s current account balance to ________.
A) rise; fall
B) rise; rise
C) fall; rise
D) fall; fall
6) A large open economy increases its desired saving. This causes the world real interest rate to
________ and the country’s current account balance to ________.
A) fall; fall
B) remain unchanged; rise
C) fall; rise
D) remain unchanged; fall
7) In a two-economy model of the United States and another large economy made up of the rest
of the world, if desired saving by the rest of the world declined
A) U.S. investment would increase.
B) U.S. saving would decrease.
C) the world real interest rate would increase.
D) the world real interest rate would decrease.
8) When a temporary adverse supply shock hits a large open economy, it causes the current
account to ________ and investment to ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
9) When future labor income falls in a large open economy, it causes the current account to
________ and investment to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; fall
D) rise; rise
10) When future labor income rises in a large open economy, it causes the current account to
________ and investment to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; fall
D) rise; rise
11) If there’s an increase in the future marginal product of capital in a large open economy, it
causes the current account to ________ and saving to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; rise
12) If business taxes rise in a large open economy, it causes the current account to ________ and
saving to ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
13) A large country imposes capital controls that prohibit foreign borrowing and lending by
domestic residents. The country is currently running a financial account surplus. The imposition
of the capital controls will cause
A) net exports to decrease.
B) real domestic interest rates to rise.
C) real world interest rates to rise.
D) desired national saving to fall.
14) A large country imposes capital controls that prohibit foreign borrowing and lending by
domestic residents. The country is currently running a financial account deficit. The imposition
of the capital controls will cause
A) net exports to increase.
B) real domestic interest rates to rise.
C) real world interest rates to fall.
D) desired national saving to fall.
15) Real domestic interest rates would increase in a large open economy if
A) there were a temporary negative domestic supply shock.
B) the government imposed capital controls and the capital and financial account had been in
deficit.
C) foreigners were more willing to save.
D) there were a temporary negative supply shock abroad in a small open economy.
16) A large open economy’s real interest rate will decrease if
A) the expected future marginal product of domestic capital rises.
B) the expected future marginal product of foreign capital rises.
C) there is a temporary positive domestic supply shock.
D) there is a temporary negative domestic supply shock.
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17) Suppose the development of the European Union leads to greater investment in Europe.
You’d expect
A) a recession in Europe.
B) a decline in the world real interest rate.
C) a rise in the current account in Europe.
D) an increase in the world real interest rate.
18) A large open economy has desired national saving of Sd = 1200 + 1000rw, and desired
national investment of Id = 1000 – 500rw. The foreign economy has desired national saving of
= 1300 + 1000rw, and desired national investment of = 1800 – 500rw. The
equilibrium world real interest rate equals
A) 0.05.
B) 0.10.
C) 0.15.
D) 0.20.
19) A large open economy has desired national saving of Sd = 1200 + 1000rw, and desired
national investment of Id = 1000 – 500rw. The foreign economy has desired national saving of
= 1300 + 1000rw, and desired national investment of = 1800 – 500rw. In equilibrium,
the foreign country has net exports equal to
A) 500.
B) 350.
C) -350.
D) -500.
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20) In a large open economy, the home country’s saving and investment equations are: Sd = 200
+ 700rw and Id = 300 – 200rw. The foreign country’s saving and investment equations are: Sd =
50 + 300rw and Id = 75 – 50rw. In equilibrium, the world real interest rate =
A) 0.10.
B) 0.20.
C) 0.25.
D) 0.40.
21) A large open economy has desired national saving of Sd = 20 + 200rw, and desired national
investment of Id = 30 – 200rw. The foreign economy has desired national saving of = 40 +
100rw, and desired national investment of = 75 – 400rw.
(a) Calculate the equilibrium values of rw, CA, CAFor, S, I, SFor, and IFor.
(b) Suppose Sd rises by 45, so that now Sd = 65 + 200rw. Calculate the equilibrium values of rw,
CA, CAFor, S, I, SFor, and IFor.
(c) Suppose, with Sd back to Sd = 20 + 200rw, as in part (a), that Id rises by 45, to Id = 75 –
200rw. Calculate the equilibrium values of rw, CA, CAFor, S, I, SFor, and IFor.
Answer:
22) A large open economy has desired national saving of Sd = 1200 + 1000 rw, and desired
national investment of Id = 1000 – 500rw. The foreign economy has desired national saving of
= 1000 + 1000rw, and desired national investment of = 1800 – 500rw. Calculate the
equilibrium values of rw, CA, CAFor, S, I, SFor, and IFor.
23) In a large open economy, the home country’s saving and investment equations are:
Sd = 200 + 1400 rw and Id = 300 – 400 rw.
The foreign country’s saving and investment equations are:
Sd = 50 + 600rw and Id = 75 – 100 rw.
Calculate the equilibrium world real interest rate, saving and investment in each country, and the
current account balance in each country.
24) Consider a large open economy that has a zero current account balance. What are the effects
on the world real interest rate, national saving, investment, and the current account balance in
equilibrium if
(a) future income rises?
(b) business taxes decline?
(c) government purchases decline?
(d) the future marginal product of capital declines?
25) Consider a large open economy. What are the effects, in equilibrium, on the world real
interest rate, domestic national saving, domestic investment, the domestic current account
balance, foreign national saving, foreign investment, and the foreign current account balance in
each of the following scenarios? Show a diagram to illustrate your results.
(a) current income rises in the foreign country
(b) the future marginal product of capital rises in the domestic country
(c) wealth rises in the foreign country
26) Consider a large open economy that has a positive current account balance.
(a) Suppose the domestic government increases the tax rate on firm revenues. Draw a diagram to
explain the effects on the world real interest rate, saving in each country, investment in each
country, and the current account balance in each country in equilibrium. Explain your work.
(b) In addition to the tax increase in part (a), suppose now that the foreign government increases
lump-sum taxes on individuals. Draw a new diagram to incorporate the overall effects of both tax
changes and explain the effects (from the initial equilibrium with neither tax change) on the
world real interest rate, saving in each country, investment in each country, and the current
account balance in both countries. Explain your work.
Answer:
5.5 Fiscal Policy and the Current Account
1) Assuming no change in the effective tax rate on capital, a decrease in the government budget
deficit will reduce the current account deficit if and only if the decrease in the budget deficit
A) reduces desired national saving.
B) increases desired national saving.
C) reduces desired national investment.
D) increases desired national investment.
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2) Assuming no change in the effective tax rate on capital, an increase in the government budget
deficit will reduce the current account deficit if and only if the increase in the budget deficit
A) reduces desired national saving.
B) increases desired national saving.
C) reduces desired national investment.
D) increases desired national investment.
3) Assume that an increase in Costa Rica’s government budget deficit reduced desired national
saving by 10 million colon. Assuming Costa Rica is a small open economy, you would expect
the government’s action to
A) increase the current account balance by exactly 10 million colon.
B) increase the current account balance by less than 10 million colon.
C) reduce the current account balance by exactly 10 million colon.
D) reduce the current account balance by more than 10 million colon.
4) An increase in a small open economy’s government budget deficit that reduces national saving
and the current account balance causes an
A) increase in desired saving.
B) increase in the world real interest rate.
C) increase in exports.
D) increase in absorption.
5) Consider a small open economy with desired national saving of Sd = 200 + 10,000rw and
desired investment of Id = 1000 – 5000rw. If rw = 0.05, then a rise in government spending of 50
with no change in private saving causes net exports to become
A) 100.
B) 50.
C) -50.
D) -100.
6) In a large open economy like the United States, an increased government budget deficit which
reduces national saving
A) reduces investment and improves the current account balance.
B) reduces investment and reduces the current account balance.
C) has no effect on investment, but reduces the current account balance.
D) has no effect on either investment or the current account balance.
7) Suppose the government of a small open economy reduces its spending, so that national
saving increases. The result is
A) an increase in the real interest rate.
B) an increase in net exports.
C) a decrease in the real interest rate.
D) an increase in investment.
8) Suppose the government of a large open economy reduces its spending, so that national saving
increases. The result is
A) a decrease in the foreign country’s net exports.
B) an increase in the real interest rate.
C) an increase in the foreign country’s net exports.
D) a decrease in investment.
9) A large open economy has desired national saving of Sd = 1200 + 1000rw, and desired
national investment of Id = 1000 – 500rw. The foreign economy has desired national saving of
= 1300 + 1000rw, and desired national investment of = 1800 – 500rw. Suppose the
foreign country’s government increases its spending by 300 and private saving does not change.
Then in equilibrium, the foreign country has net exports equal to
A) 500.
B) 350.
C) -350.
D) -500.
10) What were the principal causes of the U.S. government budget deficits of the 1980s? How
did these budget deficits lead to the twin deficits? According to the Ricardian equivalence
proposition, should twin deficits arise as a result of tax cuts?
11) Due to a change in the regulatory structure of a small open economy, the desired capital
stock becomes higher for both private investment and government investment. Increased
government investment spending is financed by borrowing, not by higher taxes. If both desired
investment and government spending rise at the same time, will there be “twin deficits”?
12) The government of a small open economy announces a tax cut of $100 this year, combined
with a tax increase of $110 next year, when the interest rate is 10%. What are the effects of this
change on the world real interest rate, national saving, investment, and the current account
balance in equilibrium when
(a) Ricardian equivalence holds?
(b) Ricardian equivalence does not hold?