In 1995, Newt Gingrich, the Speaker of the U.S. House of Representatives, threatened to send the United States into default on its debt. During the day of this announcement, U.S. interest rates rose and the real exchange rate of the U.S. dollar depreciated. Which of the following changes is consistent with the results of the open-economy macroeconomic model?
A)a fall in U.S. interest rates and an increase in net capital outflow
B)an appreciation of the real exchange rate of the U.S. dollar
C)an increase in U.S. interest rates and a depreciation of the U.S. dollar
D)an appreciation of the U.S. dollar and an increase in U.S. net capital outflow

Question

Quizplus · Accepted Answer

According to the open-economy macroeconomic model, an increase in the perceived risk of default would lead to an increase in U.S. interest rates (as investors demand higher returns to compensate for the increased risk) and a depreciation of the U.S. dollar (as investors move their money to countries with lower perceived risk). Therefore, option C is the most likely outcome. Option A is inconsistent, as an increase in interest rates would typically lead to an increase in net capital inflows, not outflows. Option B is also inconsistent, as a threat of default would typically lead to a depreciation of the currency, not an appreciation. Option D is partially accurate, as a threat of default could lead to an increase in net capital outflow, but not necessarily an appreciation of the currency.