Country A is a small open economy. Suppose there is a world war going on, and countries at war
increase their government purchases. Country A is not at war. Use diagrams to answer the following
questions.
(a) How would this world war affect the trade balance and the real exchange rate in Country A?
(b) Now suppose citizens in Country A reduce purchases of foreign goods as an anti-war movement. Does this amplify or reduce the effect of world war on Country A’s trade balance and real exchange rate?
(c) Suppose the effect of world war dominates the effect of citizens’ distaste for foreign goods. Now the fiscal policymakers of Country A want to adjust government purchases to maintain the exchange rate at its pre-war level. What should they do? If they do this, what are the overall effects of this policy on saving, investment, net exports, and interest rate?
