Answer: In a small open economy where the domestic interest rate (r^D) is lower than the world interest rate (r*), and there is an increase in G* (government spending in the rest of the world), the following effects can be observed:
Explanation: Here is a graph that shows the effects of an increase in government spending in a small open economy:
The initial equilibrium is at point A, where the IS curve intersects the LM curve. The IS curve shows all combinations of output and interest rates where the goods market is in equilibrium. The LM curve shows all combinations of output and interest rates where the money market is in equilibrium.
When government spending increases, the IS curve shifts to the right. This is because the increase in government spending increases aggregate demand, which leads to higher output and higher interest rates. The new equilibrium is at point B, where the IS curve intersects the LM curve.
The increase in government spending leads to a number of effects:
Saving decreases. This is because the increase in government spending leads to higher income, which in turn leads to higher consumption.
Investment increases. This is because the increase in government spending leads to higher output, which in turn leads to higher profits.
Trade balance decreases. This is because the increase in government spending leads to higher imports, which in turn leads to a lower trade balance.
Interest rate increases. This is because the increase in government spending leads to higher demand for money, which in turn leads to higher interest rates.
Real exchange rate appreciates. This is because the increase in government spending leads to higher demand for domestic goods, which in turn leads to an appreciation of the real exchange rate.
It is important to note that these effects are only short-run effects. In the long run, the economy will adjust to the increase in government spending and the effects will be different. For example, in the long run, the increase in government spending may lead to higher inflation, which will erode the real value of government debt.