In a small open economy, when the government reduces national saving, the equilibrium real exchange rate:
A) rises and net exports fall.
B) rises and net exports rise.
C) falls and net exports fall.
D) falls and net exports rise.

Question

Quizplus · Accepted Answer

When the government reduces national saving, it typically increases the budget deficit. This can lead to an increase in interest rates as the government borrows more. Higher interest rates attract foreign investment and lead to an appreciation of the real exchange rate. However, the increase in the real exchange rate makes domestic goods relatively more expensive compared to foreign goods, reducing net exports. Therefore, the equilibrium real exchange rate rises and net exports fall.

In a Small Open Economy, When the Government Reduces National