Consider a small open economy that takes the world real interest rate as given. Suppose that initially the world real interest rate is less than the country’s autarky real interest rate. Now suppose there is a change in tax policy that leads to an increase in domestic saving supply. Which of the following is TRUE?Group of answer choicesThe economy may flip from importing capital to exporting capitalThere is an increase in the quantity of domestic investmentThere is an increase in the real interest rate paid to domestic saversNone of the other options
Question
Consider a small open economy that takes the world real interest rate as given. Suppose that initially the world real interest rate is less than the country’s autarky real interest rate. Now suppose there is a change in tax policy that leads to an increase in domestic saving supply. Which of the following is TRUE?Group of answer choicesThe economy may flip from importing capital to exporting capitalThere is an increase in the quantity of domestic investmentThere is an increase in the real interest rate paid to domestic saversNone of the other options
Solution
The statement that is true is: "The economy may flip from importing capital to exporting capital."
Here's why:
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Initially, the world real interest rate is less than the country’s autarky real interest rate. This means that it is cheaper for the country to borrow from the world market than to use its own capital, so it is importing capital.
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An increase in domestic saving supply due to a change in tax policy means that there is more capital available within the country.
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If the increase in domestic saving is significant, it could lead to a situation where the country has more capital than it needs for its own investment. In this case, it would start lending to the world market, i.e., exporting capital.
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The quantity of domestic investment and the real interest rate paid to domestic savers are determined by many factors, not just the domestic saving supply. Therefore, we cannot say for sure that they will increase.
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