a. The real interest rate of Mikros:

In the classical model of a small open economy with perfect capital mobility, the real interest rate in Mikros is determined by the world interest rate. When the government of Makros, a large open economy, raises its government expenditure, it is likely to increase the world interest rate. This is because the increased government expenditure in Makros would lead to a higher demand for loanable funds, pushing up the world interest rate. As a small open economy, Mikros cannot influence the world interest rate, so the real interest rate in Mikros would increase in line with the world interest rate.

b. The real exchange rate of Mikros:

The real exchange rate of Mikros is determined by the relative price levels between Mikros and the rest of the world. When the government of Makros increases its government expenditure, it could lead to inflation in Makros, which would increase the price level in Makros relative to Mikros. This would make Mikros's goods relatively cheaper, leading to an appreciation of Mikros's real exchange rate. This means that Mikros's currency would strengthen relative to other currencies, making its goods more expensive for foreign consumers and its imports cheaper for domestic consumers.

Question

a. The real interest rate of Mikros:

In the classical model of a small open economy with perfect capital mobility, the real interest rate in Mikros is determined by the world interest rate. When the government of Makros, a large open economy, raises its government expenditure, it is likely to increase the world interest rate. This is because the increased government expenditure in Makros would lead to a higher demand for loanable funds, pushing up the world interest rate. As a small open economy, Mikros cannot influence the world interest rate, so the real interest rate in Mikros would increase in line with the world interest rate.

b. The real exchange rate of Mikros:

The real exchange rate of Mikros is determined by the relative price levels between Mikros and the rest of the world. When the government of Makros increases its government expenditure, it could lead to inflation in Makros, which would increase the price level in Makros relative to Mikros. This would make Mikros's goods relatively cheaper, leading to an appreciation of Mikros's real exchange rate. This means that Mikros's currency would strengthen relative to other currencies, making its goods more expensive for foreign consumers and its imports cheaper for domestic consumers.

Knowee AI · Accepted Answer

a. The real interest rate of Mikros:

In the classical model of a small open economy with perfect capital mobility, the real interest rate in Mikros is determined by the world interest rate. When the government of Makros, a large open economy, raises its government expenditure, it is likely to increase the world interest rate. This is because the increased government expenditure in Makros would lead to a higher demand for loanable funds, pushing up the world interest rate. As a small open economy, Mikros cannot influence the world interest rate, so the real interest rate in Mikros would increase in line with the world interest rate.

b. The real exchange rate of Mikros:

The real exchange rate of Mikros is determined by the relative price levels between Mikros and the rest of the world. When the government of Makros increases its government expenditure, it could lead to inflation in Makros, which would increase the price level in Makros relative to Mikros. This would make Mikros's goods relatively cheaper, leading to an appreciation of Mikros's real exchange rate. This means that Mikros's currency would strengthen relative to other currencies, making its goods more expensive for foreign consumers and its imports cheaper for domestic consumers.

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