Question

Use the model of a small open economy to show what would happen to the trade balance and the real exchange rate if the US government subsidizes a specific industry. Show the initial and final equilibrium on a figure. Briefly discuss the impacts of such policy. Do you think such a policy will increase US net exports? Why or why not?

Answer 1

If the US government subsidizes a specific industry in a small open economy, the trade balance will worsen and the real exchange rate will depreciate. This policy may not increase US net exports due to potential negative effects.

Step-by-step explanation:

In a small open economy model, if the US government subsidizes a specific industry, it will lead to an increase in the trade deficit and a depreciation of the real exchange rate.

The initial equilibrium can be represented by a point where the trade balance is balanced and the real exchange rate is at its initial level. After the government subsidies, the trade balance will worsen, resulting in a higher trade deficit, and the real exchange rate will depreciate.

This policy may not increase US net exports because although the subsidies may temporarily increase the competitiveness of the subsidized industry, it can lead to negative effects such as trade retaliation, inefficient allocation of resources, and reliance on government support.