pro#7 - Econ 100B: Macroeconomic Analysis Fall 2008 Problem...

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Econ 100B: Macroeconomic Analysis Fall 2008 Problem Set #7 ANSWERS (Due September 24 - 25, 2008) A. Small Open Economy Saving-Investment Model : 1. Clearly and accurately draw and label a diagram of the Small Open Economy Saving-Investment Model. 2. Provide an economic explanation of the shape of the curve(s) in your diagram in #1. The desired saving function is the positive relationship between desired saving and the real interest rates. The desired saving function slopes upward because an increase in the real interest rate will increase desired saving because the reward to saving has increased (the substitution effect), the cost to borrowers has increased (a negative income effect), and the benefit to savers has increased (a positive income effect). Empirical evidence suggests that the first two effects are larger than the last effect, i.e., the net effect is positive but inelastic. The desired investment function is the inverse relationship between desired investment and the real interest rate. I d S d S d , I d r r w CA > 0 I d S d
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The desired investment function slopes downward because an increase in the real interest rate will raise the tax-adjusted user cost of capital, making it more expensive to acquire new capital, thereby reducing the desired capital stock, and reducing desired investment. The world interest rate may be above (as I have drawn it), at, or below the interest rate that would establish equilibrium in a closed economy. Because in a small open economy, the world interest rate is exogenous, it does not change with the level of desired saving or desired investment in the economy. When the world interest rate is above the closed economy equilibrium interest rate, desired saving will exceed desired investment. This “excess” supply of saving at the world interest rate will lead to net foreign lending, a capital and financial account deficit, and a current account surplus. If the world interest rate is below the closed economy equilibrium interest rate, desired investment will exceed desired saving. This “excess” demand for saving at the world interest rate will lead to net foreign borrowing, a capital and financial account surplus, and a current account deficit. 3. List the endogenous and exogenous variables in this model. Same as in the closed economy desired saving-desired investment model with the deletion of the domestic interest rate as an endogenous variable (it disappears from the analysis) and the addition of the current account balance as an endogenous variable and the world interest rate as an exogenous variable. Endogenous: desired saving, desired consumption, desired investment, the current account balance. Exogenous: the world interest rate, wealth, expected future income, government purchases, taxes, expected future marginal product of capital, and the tax-adjusted user cost of capital when it comes from changes in the price of capital and/or the effective corporate tax rate. (The depreciation rate is also an exogenous variable but we typically ignore it in our analysis
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This note was uploaded on 10/14/2008 for the course ECON 100B taught by Professor Wood during the Fall '08 term at Berkeley.

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pro#7 - Econ 100B: Macroeconomic Analysis Fall 2008 Problem...

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