Answer: Here are the effects of an increase in G* in a small open economy where domestic interest rate is lower than the world interest rate (r^D< r*):
- Saving: Saving will decrease. This is because an increase in G* will lead to an increase in income, which will increase consumption and decrease saving.
- Investment: Investment will increase. This is because an increase in G* will lead to an increase in demand for goods and services, which will increase investment.
- Trade balance: The trade balance will decrease. This is because an increase in G* will lead to an increase in imports, which will offset the increase in exports.
- Interest rate: The interest rate will increase. This is because an increase in G* will lead to an increase in demand for money, which will increase the interest rate.
- Real exchange rate: The real exchange rate will appreciate. This is because an increase in G* will lead to an increase in the demand for domestic currency, which will appreciate the real exchange rate.
Explanation: Here is a more detailed explanation of each of these effects:
- Saving: An increase in G* will lead to an increase in income, which will increase consumption and decrease saving. This is because people will have more money to spend, and they will be more likely to spend it on goods and services rather than save it.
- Investment: An increase in G* will lead to an increase in demand for goods and services, which will increase investment. This is because businesses will see an increase in demand for their products, and they will be more likely to invest in order to meet this demand.
- Trade balance: The trade balance will decrease. This is because an increase in G* will lead to an increase in imports, which will offset the increase in exports. This is because an increase in G* will lead to an increase in income, which will increase the demand for goods and services. Some of this demand will be met by domestic production, but some of it will be met by imports. As a result, imports will increase. Exports may also increase, but not by as much as imports. As a result, the trade balance will decrease.
- Interest rate: The interest rate will increase. This is because an increase in G* will lead to an increase in demand for money, which will increase the interest rate. This is because people will need more money to buy the goods and services that are being produced, and they will be willing to borrow money to do so. As a result, the demand for money will increase, and the interest rate will increase.
- Real exchange rate: The real exchange rate will appreciate. This is because an increase in G* will lead to an increase in the demand for domestic currency, which will appreciate the real exchange rate. This is because people will want to hold more domestic currency in order to buy the goods and services that are being produced. As a result, the demand for domestic currency will increase, and the real exchange rate will appreciate.