Under full employment conditions an decrease in the desired level of domestic consumption at each level of income will
1. shift SI to the left, raise the real exchange rate and reduce the current account surplus.
2. shift SI to the right, lower the real exchange rate and increase the current account surplus.
3. shift CB to the right, raise the real exchange rate increase the current account surplus.
4. shift CB to the left, lower the real exchange rate and reduce the current account surplus.
Choose the correct option.
The correct answer is option 2. The decrease in desired consumption at each level of income will raise savings. This will increase the net capital outflow, shifting the vertical SI line to the right. Equilibrium will be reestablished at a lower real exchange rate and the current account surplus (deficit) will increase (fall).
One possible source of error is shifting SI in the wrong direction as a result of not realizing that savings increases, or not understanding that the distance of SI from the vertical axis is the excess of savings over investment. Another possible error is thinking that a change in savings shifts CB. This cannot happen because none of the factors, other than income, that affect savings appear as determinants of the balance of trade. The debt service balance, of course, is determined by the net capital flows that occurred in previous periods.