Equilibrium level of economic output, Microeconomics

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Provide an economic explanation of what you have shown in your diagram above.  Iceland was a small open economy with perfect capital mobility. Consequently, the equilibrium domestic real interest rate was equal to the world real interest rate, i.e., r0 = rw. At an equilibrium real interest rate of r0, desired investment was I0 while desired saving was S0. Iceland also had a trade deficit. Thus, the world real interest rate was below the real interest rate at which national saving and  domestic investment were equal. At r0 = rw, desired investment, I0, will exceed desired saving, S0, i.e., I0 > S0, the difference being financed by net capital inflows, which is equivalent to a net export deficit of NX0, i.e., NX0 = S0 - I0.

In 2008, Iceland suffered a major financial crisis which led to a sharp decline in expected future income. Based only on this additional information, clearly and accurately show the effects of the financial crisis on Iceland's (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance in your diagram above. These effects should be drawn in RED. Discuss what happens to Iceland's (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance. Be sure to explain why this takes place.

A major financial crisis reduced the equilibrium level of economic output (and income). A decline in economic output (and income) would also reduce national saving. This can be represented by a leftward shift of the desired saving function from SD0 to SD1a. However, a sharp decline in expected future income would increase desired saving at any given real interest rate. This can be represented by a rightward shift of the desired saving function from SD1a to SD1.

Because Iceland is a small open economy is equilibrium domestic real interest rate is still equal to the world real interest rate, i.e., r1 = rw. As a result, there has been no change in desired investment, i.e., I1 = I0, and the net export deficit increased by exactly the amount of the decline in national saving. i.e., NX1 - NX0 = S1 - S0.

As a result of these two changes Iceland's (1) equilibrium real interest rate has not changed, i.e., r1 = r0 = rw; (2) desired saving has declined from S0 to S1; (3) desired investment has not changed, i.e., I1 = I0, and (4) the net export balance has declined from NX0 to NX1, i.e., there is a larger trade deficit.

 


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