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ch6answers - Answers to Practice Exercises for Chapter 6 1...

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Answers to Practice Exercises for Chapter 6 1. Answer to Analytical Exercise 3 Potential output is unchanged. An increase in taxes will increase government savings, and so reduce the equilibrium real interest rate. Hence investment spending will rise, the value of the exchange rate will rise, and net exports will rise. These increases will be offset by a fall in private consumption spending. 2. Answers to Policy Exercises Exercise 1: The increase in consumption spending of $20 billion a year is a $20 billion a year withdrawal of savings from the flow-of-funds. A 1%-point increase in the interest rate reduces investment by $9 billion. A 1-percent-point increase in the interest rate also leads to a 10 point increase in the real exchange rate ε . The 10 point increase in the real exchange rate ε , in turn, reduced net exports by $6 billion. So in equilibrium the interest rate must rise by 1 1/3% in order to make supply equal to demand in the flow of funds market—in order for the reduction in investment to equal the reduction in savings from abroad (produced by the change in exports) and the reduction in private saving (produced by the consumption boom). (See equation (6.9))
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