Consider the open-economy loanable funds model with flexible prices and capital mobility. Suppose that the world consists of a small open economy (we call this domestic) and the rest of the world (we call this foreign). Answer the following questions with the aid of figures where appropriate.

a. How does an increase in domestic government expenditure affect trade balance and real exchange rate?
b. How does an increase in foreign government expenditure affect the trade balance and the real exchange rate? How does it affect domestic investment?
c. Suppose that foreign demand for goods from domestie suddenly fall, how would this affect saving, investment, net exports, the interest rate, and the exchange rate for domestie?

Part A) An expansion in government spending squeezes the local cash to acknowledge, prompting current record decay and to an abatement in utilization through a universal hazard sharing condition. An ascent in government spending causes an exchange shortfall, a genuine devaluation of the local money, and an expansion in utilization.  

Part B) After an expansion in government spending of 1 percent of GDP, the genuine swapping scale increases in value by more than 3 percent on sway and by up to 5 percent two years after the stun. The impact on the conversion scale is generally articulated in nations with an adaptable swapping scale.  

An ascent in government spending actuates a genuine conversion scale devaluation and an exchange balance shortage.  

Part C) A lessening in outside interest prompts a decline in yield and to an exchange shortfall . An expansion in local interest prompts an increase in local yield, yet drives additionally to a decay of the exchange balance.

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Explanation:

A) How does an increase in domestic government expenditure affect trade balance and real exchange rate?

When the government or Federal Reserve uses monetary or fiscal policy to expand the economy, this increases our income and our demand for imports, and ultimately lowers the exchange rate. Contractionary policies have the opposite effect. ... This decreases the demand for dollars and decreases the exchange rate.

B) How does an increase in foreign government expenditure affect the trade balance and the real exchange rate? How does it affect domestic investment?

Gross Domestic Product and Inflation

Many of us would agree that we want to live in a country that is competitive and has a good standard of living compared to other countries around us. Many of us would also probably like the option to buy relatively cheap foreign products for our everyday use. Most economists would also agree that one of the primary international goals of macroeconomic policy is to maintain the position of the U.S. as one of the leaders in the world economy.

But how does one measure all of this? That is where the debate begins. Some believe a balance of trade deficit or surplus is the key measurement. Other economists might argue that we should look at the value of the exchange rate. This lesson will focus on the exchange rate and how fiscal and monetary policies can affect it and the prices we pay for goods every day.

C) Suppose that foreign demand for goods from domestie suddenly fall, how would this affect saving, investment, net exports, the interest rate, and the exchange rate for domestie?

The exchange rate has an effect on the trade surplus (or deficit), which in turn affects the exchange rate, and so on. In general, however, a weaker domestic currency stimulates exports and makes imports more expensive. Conversely, a strong domestic currency hampers exports and makes imports cheaper.

An increase in domestic saving shifts the saving curve to the right; as a result, the trade balance and net capital outflow both increase. An increase in domestic investment shifts the investment curve to the right, causing both the trade balance and net capital outflow to decrease.

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