Question

Consider a small open economy that cannot influence the world real interest rate. For each section, draw an investment-saving diagram and show how the saving curve and/or investment curve would change. Then indicate the change in the equilibrium current account balance (CA), equilibrium national saving (S), equilibrium investment (I). Assume that output equals full-employment output, the equilibrium level of employment is fixed, and initially the current account balance is zero.

a) The government raises income taxes.
b) A natural disaster destroys an important fraction of the nation's physical capital stock.
c) The world real interest rate falls.

Answer 1

In a small open economy, changes in income taxes, physical capital stock, and world real interest rate can impact national saving, investment, and current account balance.

Step-by-step explanation:

In a small open economy that cannot influence the world real interest rate, several scenarios can impact the investment-saving diagram and equilibrium current account balance (CA), national saving (S), and investment (I).

a) If the government raises income taxes, it will reduce the disposable income available for households to save. This will shift the saving curve to the left, reducing national saving (S) and investment (I), and leading to a decrease in the current account balance (CA).

b) If a natural disaster destroys a significant fraction of the nation's physical capital stock, it will reduce investment. This will shift the investment curve to the left, reducing investment (I) and national saving (S), and leading to a decrease in the current account balance (CA).

c) If the world real interest rate falls, it will make domestic investment relatively more attractive than foreign investment. This will shift the investment curve to the right, increasing investment (I) and national saving (S), and leading to an increase in the current account balance (CA).