Consider a large open economy that can borrow and lend with the rest of the world. For each question below make sure you draw the graphs and provide explanations.
a. Draw the saving and investment diagram for the home country assuming the home country is running a current account deficit. Explain how the world real interest rate is determined.
b. Suppose new products are developed in the home country that raises the profitability of domestic industries. Assuming that this raises the demand for capital, explain what will happen to the current account balance in the home country and in the foreign country. What happens to the real world interest rate?
c. Suppose the domestic economy goes into a deep recession and the investment demand falls dramatically. What happens to the current account balance in the home country and the foreign country? What will be the correlation of the trade balance and the unemployment rate?
d. Suppose the home country increases government spending without and lowers taxes. How will this impact the current account balance in the home country and the foreign? What happens to the world interest rate?