Assume that some large foreign countries decide to subsidize investment by instituting an investment tax credit. Then the home country's real exchange rate will fall and its net exports will rise.
I completely don't understand the above statement because I don't know what investment tax credit is. What is it?
An investment tax credit reduces the amount of taxes paid to the government.
http://www.answers.com/topic/investment-tax-credit
An investment tax credit (ITC) is a type of subsidy provided by a government to incentivize businesses to make investments in certain areas of the economy. It works by allowing businesses to reduce their tax liability by a certain percentage of the value of their investment. This means that businesses can deduct a portion of their investment costs from their taxes, effectively reducing their tax burden.
Now, let's understand how the statement you mentioned connects an investment tax credit to the real exchange rate and net exports. When large foreign countries introduce an investment tax credit, it encourages businesses in those countries to increase their investment activities. This leads to increased spending on capital goods and equipment, which are often imported from other countries.
As a result, the demand for imports by those countries increases. To meet this demand, the foreign countries will need to exchange their currency for the currency of the home country to pay for the imported goods. This increased demand for the home country's currency raises the value of the home country's exchange rate.
A higher exchange rate means that the home country's currency becomes relatively more expensive compared to other currencies. This makes the home country's goods and services more expensive for foreign buyers. As a result, the demand for exports from the home country decreases.
On the other hand, the increased investment in the foreign countries, fueled by the investment tax credit, leads to increased production and output. This stimulates the economy and creates job opportunities. As a result, domestic consumption in those foreign countries also increases.
Therefore, with higher spending on imports and lower demand for exports, the home country's net exports (exports minus imports) are likely to decline. This implies that its trade balance may turn negative, leading to a rise in net exports.
In summary, the introduction of an investment tax credit by large foreign countries can lead to a decrease in the home country's real exchange rate and an increase in its net exports.