Oceania is a small open economy. Suppose that a large number of foreign countries begin to subsidize investment by instituting an investment tax credit (while adjusting other taxes to hold their tax revenue constant), but Oceania does not institute such an investment subsidy.
a. What happens to world investment demand as a function of the world interest rate?
b. What happens to the world interest rate?
c. What happens to investment in Oceania?
d. What happens to Oceania's trade balance?
e. What happens to Oceania's real exchange rate?
Investment Tax Credit:
A reduction in income tax which is generally based on the cost and life of certain assets purchased is referred to as investment tax credit. A proportion of the purchase price is given as a credit against the taxpayer's income taxes with an objective to stimulate business investment in capital goods.
Answer and Explanation:
(a) If the countries that institute an investment tax credit are large enough to shift the world investment demand schedule, the direct consequence is an upward shift in the world investment demand schedule.
(b) The world interest rate would rise.
(c)Since the investment schedule slopes downward, a higher world interest rate implies lower investment in Oceania.
(d)Oceania's trade balance would increase.
(e) The increase in the world interest rate reduces investment in the domestic economy leading to an increase in the supply of dollars that are available to invest abroad. Consequently, the value of domestic currency falls and domestic goods become less expensive relative to foreign goods. Thus, the real exchange rate falls.
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from Finance 305: Risk ManagementChapter 3 / Lesson 3