In a large open economy, if political instability abroad lowers the net capital outflow function, then the real interest rate:
A) rises, while the real exchange rate rises and net exports fall.
B) rises, while the real exchange rate falls and net exports rise.
C) falls, while the real exchange rate rises and net exports rise.
D) falls, while the real exchange rate rises and net exports fall.

Question

Quizplus · Accepted Answer

In a large open economy, a lower net capital outflow function means that domestic residents are less willing to invest abroad. This leads to a decrease in the demand for foreign currency, which causes the real exchange rate to appreciate (i.e., the domestic currency becomes more expensive relative to foreign currencies). As a result, net exports fall because domestic goods become more expensive relative to foreign goods. To offset the decrease in net exports, the central bank must raise the real interest rate to attract foreign capital inflows.

In a Large Open Economy, If Political Instability Abroad Lowers