Consider a small open economy in equilibrium. What happens to the real interest rate, national saving, investment, and the current account balance in equilibrium in each of the following situations (each taken separately)

Question

Explain which curve shifts and why, and show a diagram explaining your results. (You may assume that none of the shocks is large enough to significantly affect labor supply or labor demand significantly.)
(a) wealth declines
(b) business taxes decline
(c) income rises temporarily

Answer 1

(a) The decline in wealth causes desired consumption to decline today and in the future; with no decline in current income, desired saving increases, so the desired saving curve shifts right. The world real interest rate is unchanged, so investment is unchanged, saving increases, and the current account balance increases.
(b) A decline in business taxes leads to a decline in the user cost of capital, increasing the desired capital stock and thus desired investment. As a result, the desired investment curve shifts right. In equilibrium, the world real interest rate is unchanged, so saving is unchanged, investment increases and the current account balance declines.
(c) A temporary increase in income causes desired saving to increase, as people will only spend part of the increase in income currently. In equilibrium, the shift to the right in the desired saving curve does not affect the world real interest rate or investment, but saving rises as does the current account balance.