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Use the classical IS-LM model for two countries to analyze the idea that the United States became a relatively more attractive place to invest in the early 1980s. Assume that, because of more favorable tax laws, the user cost of capital falls in the domestic country and that, because of the LDC debt crisis, the expected future marginal product of capital falls in the foreign country. Suppose the effects from the declining domestic user cost dominates, show that these changes lead to an appreciation of the home country's real exchange rate and a drop in the domestic country's net exports. Assume no change in current productivity or current labor supply in either country. What is happening to financial flows? Why?

Microeconomics, Economics

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