In a two-good,two-period model,as long as wealth effects are small,an increase in the world real interest rate

Question

Quizplus · Accepted Answer

In a two-good, two-period model, an increase in the world real interest rate typically induces substitution effects and income effects. The substitution effect tends to increase savings and reduce consumption, while the income effect can increase or decrease consumption, depending on whether consumption of the good is normal or inferior.

If the income effect is larger than the substitution effect, an increase in the world real interest rate can decrease consumption and increase savings. This, in turn, leads to an increase in the current account surplus, as savings have to be invested abroad to earn the higher interest rate.

Therefore, choice C is the best answer, as it reflects the possibility that the income effect dominates and leads to a decrease in consumption and an increase in the current account surplus.

In a Two-Good,two-Period Model,as Long as Wealth Effects Are Small,an