Question

In a large open economy, if political instability abroad lowers the net capital outflow function, then the real interest rate: A) rises, while the real exchange rate rises and net exports fall. B) rises, while the real exchange rate falls and net exports rise. C) falls, while the real exchange rate rises and net exports rise. D) falls, while the real exchange rate rises and net exports fall.

Answer 1

Answer:

In a large open economy, if political instability abroad lowers the net capital outflow function, then the real interest rate falls, while the real exchange rate rises and net exports fall. (D)

Explanation:

NX = EXPORTS – IMPORTS

If political instability abroad lowers the net capital outflow function that would mean that NX is reducing, which increasing imports and decreasing exports. This means that domestic goods are relatively more expensive due to a high exchange rate. In terms of the real interest rate, it falls because the demand for financial assets decreases.