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 relationshipbetween 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 relationshipbetween desired investment and the real interest rate. IdSdSd, Idr rwCA > 0IdSd
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