What happens to the real exchange rate if domestic investment demand increases, for example by virtue of a government measure granting tax relief to investments? An increase in domestic investment demand results in a higher level of investment for any given level of the prevailing world interest rate. As I increases, S - I and NX decrease. Thus, an increase in investment demand generates a trade deficit.
As the graph shows, the increase in investment demand causes a shift to the left of the vertical line S – I, reducing the supply of national currency available for investment abroad and thus increasing the equilibrium exchange rate. Therefore, tax breaks make domestic investment more convenient but, at the same time, increase the relative value of the national currency needed to finance the investment itself. As the national currency appreciates, domestic goods become relatively more expensive and net exports decline.
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