1. equilibrium in the big country does not depend significantly happens in the small country.
2. equilibrium in the small country depends significantly on what happens in the big country.
3. the world rate of interest will be determined by the intersection of the big country's IS and LM curves.
4. all of the above are true.
Choose the correct option.
The correct answer is option 4. Because the small country is so small in relation to the big country, a major increase in its exports relative to its imports will constitute a trivial increase in the big economy's imports relative to its exports, taken in proportion to initial levels. Also, a major portfolio shift between money and other assets in the small country will have a trivial effect on the world demand for assets and hence on the world interest rate. Equilibrium in the big country, as determined by the intersection of its IS and LM curves, will thus not be affected by what happens in the small country but will determine the world interest rate and the world price of the traded components of output and the big country's price level, all of which are important determinants of small-country equilibrium.