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Increase in domestic government expenditure

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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 domestic suddenly fall, how would this affect saving, investment, net exports, the interest rate, and the exchange rate for domestic?

d. The government of domestic responds to this policy in order to stabilize the exchange rate. What kind of trade policy can they implement? What would be the effects on investment, net exports, and the interest rate? What about the volume of trade?

Reference no: EM132476202

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