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# answerstohomework3spring2007 - Economics 302 Spring 2007...

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Economics 302 Spring 2007 Answer Key: Homework 3 1. a. Y = 2000. C = 1375. S = 2000-1375-700 = -75. Using the condition S=I implies r=21.5. The graph is the standard one used in section: national savings is a vertical line, the investment demand function is linear, downward sloping and crosses the y-axis at I =1000. b. In an open economy, the domestic interest rate will equal the world interest rate. The assumption needed to get this is that of perfect capital mobility. Under perfect capital mobility and a world interest rate r*, domestic firms would never pay a domestic investor more than r*, since it could always get a cheaper loan on the international capital market. At the same time, a domestic investor would never lend to a firm at less than r*, since it could always lend its money to a foreign firm and earn return r*. Thus, the equilibrium domestic interest rate with a small open economy must have r=r*. The appropriate graph should demonstrate that it is the interest rate r=5% which is fixed first. Given this, you can find I(r) from the investment demand curve.

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