Graphical show and discuss how the following fiscal policy shifts the SI curve and show its effect on income and interest rate in the closed economy.
A. Decrease in government expenditure
B. Increase in tax
C. Show the effect of above policy in the open economy case, both in the fixed and flexible rate.
In a closed economy, the Savings-Investment (SI) curve represents the equilibrium relationship between savings and investment in the economy. A shift in fiscal policy can affect this equilibrium by changing government expenditure or taxes.
A. Decrease in government expenditure:
When government expenditure decreases, it leads to a shift in the SI curve to the left. This is because lower government spending means there is less demand in the economy, leading to a decrease in income. The graph below illustrates this shift:
[Graph]
The decrease in government expenditure leads to a decrease in income (Y) and a decrease in the interest rate (r) in the closed economy.
B. Increase in tax:
When taxes increase, it leads to a decrease in disposable income, which in turn leads to a decrease in consumption and, consequently, a decrease in income. This results in a leftward shift of the SI curve. The graph below illustrates this shift:
[Graph]
The increase in taxes leads to a decrease in income (Y) and a decrease in the interest rate (r) in the closed economy.
C. Open economy case:
In an open economy, the effects of fiscal policy are more complex due to the presence of international trade and capital flows. In the fixed exchange rate regime, the exchange rate is fixed, while in the flexible exchange rate regime, the exchange rate is determined by the market.
- Fixed exchange rate regime:
In the fixed exchange rate regime, fiscal policy can lead to changes in the balance of payments due to changes in income and interest rates. For example, a decrease in government expenditure or an increase in taxes can lead to a decrease in income and a decrease in the interest rate, which can improve the trade balance.
- Flexible exchange rate regime:
In the flexible exchange rate regime, fiscal policy can lead to changes in the exchange rate due to changes in income and interest rates. For example, a decrease in government expenditure or an increase in taxes can lead to a decrease in income and a decrease in the interest rate, which can lead to a depreciation of the currency.
Overall, fiscal policy can have different effects in open economies compared to closed economies, and the exchange rate regime can also influence the transmission of these effects.