a Figure 1 shows the exogenous world interest rate (r*) determines the level of investment (I) and the difference between saving (S) and investment determines net capital outflow and net exports (NX) for a small open economy. What would happen to I, NX and S if: i. The government of this small open economy uses expansionary fiscal policy. ii. The government of other countries (abroad) uses contractionary fiscal policy. b Suppose the price of a cup of tea is Rs.50 in Pakistan and $2 in USA, the value of nominal exchange rate is $0.006364 per PKR. Calculate the value of real exchange rate (ε) and interprete its meaning. Also, discuss the relationship between net exports (NX) and real exchange rate. c Briefly explain the theory of purchasing power parity (PPP) with the help of example.

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Public Saving

Public saving deals with the amount which has been in excess after meeting all the obligatory expenses and investment of the government. Taxes are collected by the government to meet its day-to-day expenditures. The obligatory expenses include all those expenses which are mandatory for the government. It cannot be avoided as it is inevitable.