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 investment demand. 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 savingThere is an increase in the real interest rate paid by domestic investorsNone 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 investment demand. 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 savingThere is an increase in the real interest rate paid by domestic investorsNone 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 savings for investment. Therefore, the country is importing capital.
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Now, there is a change in tax policy that leads to an increase in domestic investment demand. This means that the country needs more capital for investment.
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If the increase in investment demand is large enough, it could lead to a situation where the country's demand for capital exceeds the world supply at the world interest rate. In this case, the country would need to export capital to balance its capital account.
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The other options are not necessarily true. An increase in investment demand does not necessarily lead to an increase in domestic saving. It could lead to an increase in borrowing from abroad. Also, the real interest rate paid by domestic investors is determined by the world interest rate, which is given. Therefore, it does not necessarily increase.
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