Figure 13.4 shows the effect of an increase in the world interest rate on a small open economy with perfect capital mobility. We assumed there that the Net Capital Outflow (NCO) was positive. For most of the past 40 years, however, Canada's NCO has been negative.

1. Redraw the two panels of figure 13.4, but this time assume that NCO is negative at the world interest rate. Now suppose that the world interest rate increases. What happens to national savings (S)? What happens to domestic Investment (I)? What happens to NCO and the real exchange rate? Carefully label both diagrams and explain step by step what happens starting from the initial equilibrium in both markets. Make sure to include all the relevant details step by step or you will lose marks.