1 answer

Suppose Country X is a small open economy with a huge trade deficit. Recently, her government...

Question:

Suppose Country X is a small open economy with a huge trade deficit. Recently, her government suggests a reduction in income

Suppose Country X is a small open economy with a huge trade deficit. Recently, her government suggests a reduction in income tax. Using the Classical Theories, explain what will happen to net capital outflow and real exchange rate in the long run. Explain the impact on the size of her trade deficit.

Answers

This is a part of domestic fiscal policy expansion that is likely to reduce public savings and so the S-I curve shifts to the left. As the rate of interest rises, capital flows in the nation increase more than the outflows so that there is a net capital outflow. As a result of increased demand for currency, the currency appreciates and real exchange rate rises. This causes net exports to fall and worsens the trade deficit.

Real exchange rate, e S-1 S2-1 --- - - - -- - - NX(€) NX, NX Net exports, NX

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