Question

Suppose that the government of a small open economy decides to abolish an investment tax credit while decreasing other taxes to keep tax revenue at its current level.

(a) Using the model that determines the real exchange rate, the result of the government’s abolishment of the investment tax credit, what is the small open economy’s real exchange rate? How about its level of net exports?

(b) Instead of the policy change above, suppose that the government of a foreign large open economy increases tax rates. Show the impact that this policy will have on a small open economy.

(c) As a result of the foreign government’s contractionary fiscal policy, what happens to the small open economy’s real exchange rate? How about it net exports?