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cutting government expenditures and rising interest rates

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Economic concepts

The following figure illustrates internal and external balance in an economy with capital flows. "Assume fixed exchange rate"

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The full employment output is shown as Y* so that at the point E, we have both full employment "internal balance" and balance of payment equilibrium ":external balance".

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Solution Summary

Problems about cutting government expenditures and rising interest rates are examined. The internal and external balance in an economy with capital flows are determined.

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First, you have to understand what's happening at the points E2 and E3.

In E3 the interest rates are too high for the level of demand of the economy. So the money is more expensive than it should be according to the level of output. Which is beyond the level of balance. In this case the economy is in a surplus, (S>I) but also it is producing beyond its equilibrium level, it also has low levels of unemployment. This country probably has more saving than its economy requires, the high interest rates also produce that people would prefer invest in external economies, but the rate of exchange is fixed! So, the interest rates of all countries in this world tend to be equal. So, there are no incentives to invest abroad. The ...

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