Question:
How will a fall in domestic investment affect the trade surplus and net capital outflows in the domestic economy, the trade deficit and capital inflows in the rest of the world, investment in both economies, and the world real interest rate?
Answer
A fall in domestic investment means that the production activities in the economy will decrease. This translates into a shrinking of the aggregate production in the economy, as there will be no production activities and the existing production activities will also decrease. This will lead to fall in employment level and also the aggregate output. The interest rate will also fall as the money supply is fixed while the money demand falls. Therefore, the real interest in the domestic economy will fall.
Now, this fall in interest rate will mean that there will be a capital outflow as the returns on investments in the domestic currency falls. This, in turn, will lead to a depreciation of currency as the demand for the domestic currency falls due to the capital flow. Depreciation of currency will directly impact exports and imports. For the foreign consumers this will mean that our products become cheaper. Therefore, exports will rise. Similarly, imports will become costlier for as the foreign currency will become dearer for us, leading into an increase in prices of imports. The increased exports and decreased imports will ultimately lead to an increase in the trade surplus.
Therefore, there will an increase in the capital inflow of other economies which have interest rates higher than the domestic economy. The trade deficit of rest of the world will increase, following the opposite pattern of that of the domestic economy. Also, if the domestic economy is small, there will not be any change in the world real interest rate. However, if the domestic economy is big, there will be a fall in world interest rate, as the fall in demand in the domestic economy will affect the world demand, resulting into a fall in interest rates.