# homework3Spring2008answers - Economics 302 Spring 2008...

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Economics 302 Spring 2008 Answers to Homework #3 Homework will be graded on completeness and content as well as neatness. Sloppy or illegible work will not receive full credit. This homework requires the use of Microsoft Excel. If your answer requires rounding, round to two decimal places. 1. Small Open Economy Use the following set of Classical Model equation for a small open economy to answer the following questions. Y = F (K, L) = AK α L 1-α C = C (Y – T) = 23 + .72 (Y – T) I = I (r*) = 325 – 15.5 r* (Where r is expressed as a percentage, i.e. if the interest rate is 5% then r = 5 in the equation.) Y = C + I + G + NX Y = C + S P + T G = 220 T = 155 K = 1000 L = 8000 A = 0.3 Capital’s Share of Income = 1/3 a. What is aggregate output, Y, for this economy? Y = AK α L 1-α = 0.3 * 1000 1/3 * 8000 2/3 = 0.3 * 10 * 400 = 1200 b. What is the level of consumption, C, for this economy? C = 23 + .72 (Y – T) = 23 + 0.72 (1200 – 155) = 775.4 c. What is the level of investment, I, for this economy if the world real interest rate (r*) is 7%? I = I (r*) = 325 – 15.5 r* = 325 – 15.5*7 = 216.5 d. Given the information you have found in parts a-c, find the level of net exports for this economy. NX = Y – C – I – G = 1200 – 775.4 – 216.5 – 220 = -11.9 NX = NS – I = S P + S G – I = (Y – C – T) + (T – G) – I = (1200 – 775.4 – 155) + (155 – 220) - 216.5 1

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= (269.6) + (-65) – 216.5 = -11.9 e. Is this country borrowing from or lending to foreigners? What is the relationship between domestic spending and domestic production in this economy, and how do these two topics relate to one another? Spending (C + I + G) in this economy exceeds domestic production (Y). This results in imports exceeding exports and the necessity of this economy borrowing from abroad. These two questions get at the same relationship: if you import more than you export you must be borrowing from foreigners to finance the extra purchases. f. Suppose government spending increases by 25. What are the effects of the increased government spending on output, consumption, investment, and net exports in this economy? Y = 1200 (K, A, L, and α are all constant) C = 775.4 (Y and T are constant) I = 216.5 (world real interest rate does not change with small economy) S P = 269.6 (the same as Y, C, and T remain the same) S G = (T – G) = (155 – 245) = -90 (25 less than before) NX = -36.9 (25 less than before as I and S p remained the same) g. Did the increase in government spending completely crowd out investment spending as it would have in a closed economy? Explain your answer. No, there is no change in investment spending in the open economy as a result of the increase in government spending. In the closed economy we would have seen a complete crowding out of investment spending with the increase in government spending. The increase in government spending causes a decrease in public saving. This in turn reduces the level of national saving. This leads to more imports and more capital flowing into
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## This note was uploaded on 08/08/2008 for the course ECON 302 taught by Professor Gold during the Spring '07 term at University of Wisconsin Colleges Online.

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homework3Spring2008answers - Economics 302 Spring 2008...

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