31410fps2solutions

# 31410fps2solutions - Economics 314-1 Problem Set 2...

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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

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= 250 NX = S – I = 1000 – 250 = 750 NX = 1000 – 500 x ε 750 = 1000 – 500 x ε ε = 0.5 Saving is unchanged from part (a), but the higher world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, which requires that the currency depreciate. Question 2: a. As shown in the diagrams below, an increase in government purchases reduces national saving. This reduces the supply of loans and raises the equilibrium interest rate. This causes both domestic investment and net capital outflow to fall. The fall in net capital outflow reduces the supply of dollars to be exchanged into foreign currency, so the exchange rate appreciates and the trade balance falls. r r S I + CF CF( r) S, I+CF CF ε CF NX(ε) NX
b, As shown below, the increase in demand for exports shifts the net exports schedule outward. Since nothing has changed in the market for loanable funds, the interest rate remains the same, which in turn implies that net capital outflow remains the same. The shift in the net export schedule causes the exchange rate to appreciate. The rise in the exchange rate makes U.S. goods more expensive relative to foreign goods, which depresses exports and stimulates imports. In the

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31410fps2solutions - Economics 314-1 Problem Set 2...

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