1. will reduce domestic investment.
2. will increase the current account surplus.
3. will do both of the above.
4. will do neither of the above.
Choose the correct option.
Option 3 is the correct one. The rise in the domestic interest rate directly reduces the level of domestic investment by reducing the present value of marginal projects and thereby making them unprofitable. The EE cuve shifts downward. The decline in investment reduces the inflow of capital and, hence the sale of assets to foreigners. The demand for the domestic currency declines leading to a fall in the nominal and real exchange rates at the initial level of domestic prices. This shifts world demand onto domestic goods, increasing the balance of trade to match the increased outflow (or reduced inflow) of capital, shifting the EE curve back up and allowing output and employment to remain at their full-employment levels. Since the level of income ultimately remains pretty much the same, it is unlikely that savings will decline by anywhere near the decline in domestic investment, as would be required for the devaluation of the domestic currency to be prevented. Net exports substitute for investment as full employment is maintained.
The reduction in domestic investment resulting from the rise in the domestic interest rate thus shifts the EE curve downward while the devaluation that maintains full employment shifts it upward by the same amount.