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Chapter 29: Problem 5

Suppose that Federal Reserve policy leads to higher interest rates in the United States. a. How will this policy affect real GDP in the short run if the United States is a closed economy? b. How will this policy affect real GDP in the short run if the United States is an open economy? c. How will your answer to part (b) change if interest rates also rise in the countries that are the major trading partners of the United States?

Short Answer

Expert verified
a) In a closed economy, higher interest rates can reduce real GDP in the short run due to decreased investment. b) In an open economy, a high domestic interest rate can decrease GDP because it could cause the domestic currency to appreciate, making exports more expensive and hence lesser. c) If interest rates also rise in other countries, the impact on GDP due to reduced exports may be less severe than when only domestic interest rates increase.

Step by step solution

01

Closed Economy Impact

In a closed economy scenario, higher interest rates discourage investment as the cost of borrowing increases. This decrease in investment can lead to a decrease in economic activity, hence, reducing the real GDP in the short run.
02

Open Economy Impact

In an open economy, higher interest rates can attract foreign investors due to potentially higher returns, this elevates the demand for domestic currency, hence raising its value. A stronger domestic currency makes domestic goods more expensive for foreign buyers, leading to a decrease in exports. Since exports contribute to real GDP, if they decrease (while imports remain the same or increase), real GDP can decrease.
03

Global Interest Rate Rise

If interest rates also rise in major trading partner countries, the investment attractiveness for higher domestic interest rates may reduce, as foreign investors would have comparably high returns in their own countries. The exchange rates may then not change significantly so the decrease in exports may be less extreme. Therefore, the impact on real GDP would possibly be less severe than in step 2.

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Most popular questions from this chapter

Section 29.4 states that "the budget surpluses of the late 1990 s occurred at a time of then-record current account deficits." Holding everything else constant, what would the likely effect have been on domestic investment in the United States during those years if the current account had been balanced instead of being in deficit?

An investment analyst recommended that investors "gravitate toward the stronger currencies and countries that are running current-account and fiscal surpluses," such as South Korea and Taiwan. a. Holding all other factors constant, would we expect a country that is running a government budget surplus to have a currency that is increasing in value or decreasing in value? Briefly explain. b. Holding all other factors constant, would we expect a country that has a currency that is increasing in value to have an increasing or a decreasing current account surplus? Briefly explain. c. Is the combination of economic characteristics this analyst has identified likely to be commonly found among countries? Briefly explain.

What is the relationship among the current account, the financial account, and the balance of payments?

Why might "the continued willingness of foreign investors to buy U.S. stocks and bonds and foreign companies to build factories in the United States" result in the United States running a current account deficit?

(Related to Solved Problem 29.1 on page 1034 ) An article on the Dow Jones Newswire in mid-2017 contained the following sentence: "The U.S. current- account deficit, a measure of trade and financial flows with foreign countries widened to \(\$ 116.78\) billion in the first quarter." Does a country's current account include any financial flows between that country and other countries? Does it include all financial flows between that country and other countries? Briefly explain.
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