4-Use the model of the small open economy to predict what would happen to the tr

Question

4-Use the model of the small open economy to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events. (15 marks) A fall in consumer confidence about the future induces consumers to spend less and save more. (5 marks) The introduction of a stylish line of Volkswagens makes some consumers prefer foreign cars over domestic cars. (5 marks) The introduction of automatic teller machines reduces the demand for money. (5 marks) a. b. c·

Explanation / Answer

4). a). An increased savings rate will induce the Federal Reserve to induce a reduction in interest rates, in order to facilitate current consumption in the economy. For this, the Fed will have to increase the money supply in the economy which will shift LM curve down to the right. This will reduce interest rates and increase output. Reduced interest rates will lead to outflow of foreign investment from the country, thereby leading to depreciation of domestic currency as against the foreign currency. This will make domestic goods cheaper, thereby inducing increased exports of domestic products.

4). b). The introduction of of stylish line of cars will lead to increase imports in the economy. This will increase the country's trade deficit. In order to finance this deficit, the government will buy more foreign reserves, thereby derpreciating domestic currency against foreign currency.

c). Reduction in money demand increases the interest rates, thereby reducing foreign investment in the country. This will lead to depreciation of the domestic currency as against foreign currency.

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