Consider a small open economy X that trades solely with a much larger open economy Y; in Y we can ignore any impact from X.
(a) Economy Y has a budget deficit which is financed by issuing bonds. What will be the effect on economy Y’s interest rate?
(b) Assuming the portfolio balance model is correct, what will be the effect of this foreign interest change on economy X? Draw all relevant diagrams, and explain the economics of what is going on.