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Question: Under what conditions will an increase in government debt reduce aggregate consumption in the long run, in a small open economy?

06 Oct 2022,9:27 PM

 

1. How is the ‘fundamental equation’ for the current account derived? How successful is it at explaining real-world current account behaviour?

2. If the only available internationally-traded assets are riskless bonds and equity, does this necessarily mean that the global resource allocation is Pareto-inefficient? What does empirical evidence suggest about whether there is efficient international risk-sharing?

3. Under what conditions will an increase in government debt reduce aggregate consumption in the long run, in a small open economy? Support your arguments by careful analysis of a formal model.

4. In Dornbusch’s model of exchange rate determination, explain why the dynamics have the ‘saddlepoint stability’ property. How is this relevant to the result that the exchange rate ‘overshoots’, following a money supply change?

5. What is the role of assuming that utility over different types of goods has a constant-elasticity-of-substitution (‘CES’) form, in Obstfeld and Rogoff’s twocountry model? How do the macroeconomic results depend on the magnitude of the elasticity of substitution?

 

Expert answer

 

When an increase in government debt reduces aggregate consumption in the long run in a small open economy, it is usually because the increase in government debt leads to an increase in the interest rate. This increase in the interest rate can then reduce investment and private consumption in the economy. The reduction in investment and private consumption can lead to a decrease in aggregate demand and a decrease in output in the long run.

 

The increase in government debt can also crowd out private investment in the economy. This is because when the government borrows money, it competes with the private sector for funds. This competition can drive up interest rates and make it more difficult for firms to raise capital. As a result, investment may fall and output may decline in the long run.

 

In conclusion, an increase in government debt can have negative effects on a small open economy in the long run. The increase in government debt can lead to an increase in interest rates, which can reduce investment and private consumption. The reduction in investment and private

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