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Suggested_answers_to_Quiz_2 - for private savings to fall...

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Suggested Answers to Quiz 2 Name _____________________________ 1. Let’s consider an economy with perfectly flexible prices, competitive markets and a balanced government budget G = T. Suppose that in response to increase security concerns, the country increases its government spending by 500 but must keep its budget balanced by law. Suppose that the consumption function for the economy is C = 250 + .8(DY). Suppose, too, that the investment demand function is I = 200 – 100r. a. Given the change above, what is the change in private savings, public savings and national savings? Show your work. If G rises, then T must also rise by 500 since the budget must be balanced. If T and G rise both by 500, public savings does not change. Since private savings is Y – C – T, and T rises by 500, then we know that C will fall by .8 of that change, or 400. This is because for each change in DY of 1, C changes by .8. We then know that since C falls by 400 and T rises by 500, the net change is

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Unformatted text preview: for private savings to fall by 100. Since national savings is the sum of private and public savings, national savings falls by 100. b. Given your answer to part a, will the equilibrium real interest rate change? If so, by how much? If not, explain why not. Since national savings falls, we know that the equilibrium interest rate will rise. But by how much? We know that S = I d in equilibrium, so if S falls by -100, then to maintain equilibrium, then I must fall by 100. From the investment demand function, we know that when r changes by 1, I falls by 100. Thus, r rises by 1. c. Draw a figure that illustrates what you found above. r +1 r S ‘ S I d r I, S D 100 d. Without making the calculations, how would your answer in part b change if consumption were a function of the real interest rate? If consumption were a function of the interest rate, then the change in the interest rate would be smaller since the rise in the interest rate would induce more savings....
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