Consider a small open economy that does not permit international borrowing or lending. The country’s autarky real interest rate is greater than the world real interest rate. Suppose the country removes its capital controls. Which of the following is TRUE?Group of answer choicesThere is an excess demand for capital in the domestic economy and capital flows inThere is an excess demand for capital in the domestic economy and capital flows outThere is an excess supply of capital in the domestic economy and capital flows inThere is an excess supply of capital in the domestic economy and capital flows out
Question
Consider a small open economy that does not permit international borrowing or lending. The country’s autarky real interest rate is greater than the world real interest rate. Suppose the country removes its capital controls. Which of the following is TRUE?Group of answer choicesThere is an excess demand for capital in the domestic economy and capital flows inThere is an excess demand for capital in the domestic economy and capital flows outThere is an excess supply of capital in the domestic economy and capital flows inThere is an excess supply of capital in the domestic economy and capital flows out
Solution
The correct answer is: There is an excess demand for capital in the domestic economy and capital flows in.
Here's why:
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The country's autarky real interest rate is greater than the world real interest rate. This means that the return on investment in this country is higher than elsewhere in the world.
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When the country removes its capital controls, it allows for international borrowing and lending.
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As a result, investors from around the world would want to invest in this country to take advantage of the higher interest rate. This creates an excess demand for capital in the domestic economy.
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To meet this excess demand, capital flows into the country from the rest of the world.
So, the statement "There is an excess demand for capital in the domestic economy and capital flows in" is true.
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