Economics 314-1
Fall 2010
Problem Set 2 Suggested Solutions
Question 1:
a.
National saving is the amount of output that is not purchased for current consumption by
households or the government.
We know output and government spending, and the
consumption function allows us to solve for consumption.
Hence, national saving is
given by
S =
Y – C – G
= 6,000 – (500 + 0.6(6,000 – 1,000)) -1,500
= 1000.
Investment depends negatively on the interest rate, which equals the world rate r
*
of 5.
Thus,
I = 1,000 – 100 x 5
=
500.
Net exports equal the difference between saving and investment.
Thus,
NX = S – I
= 1000 – 500
= 500.
Having solved for net exports, we can now find the exchange rate that clears the foreign-
exchange market:
NX = 1000 – 500 x
ε
500= 1000 – 500 x
ε
ε
= 1.
b.
Doing the same analysis with the new value of government spending we find:
S = Y – C – G
= 6,000 –(500 + 0.6(6,000 – 1,000))
- 2,000
= 500
I = 1,000 – 100 x 5
= 500
NX = S – I
= 500 – 500
= 0.0
NX = 1000 – 500 x
ε
0.0 = 1000 – 500 x
ε
ε
= 2.0.
The increase in government spending reduces national saving, but with an unchanged
world real interest rate, investment remains the same.
c.
Repeating the same steps with the new interest rate,
S = Y – C – G
= 6,000 – (500 + 0.6(6,000- 1,000) – 1,500
= 1000
I = 1,000 – 100 x 7.5