# HW3_sol - 34 Answers to Textbook Questions and Problems 2....

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2. a. National saving is the amount of output that is not purchased for current con- sumption 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 = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750. Investment depends negatively on the interest rate, which equals the world rate r * of 5. Thus, I = 1,000 – 50 × 5 = 750. Net exports equals the difference between saving and investment. Thus, NX = S – I = 750 – 750 = 0. Having solved for net exports, we can now find the exchange rate that clears the foreign-exchange market: NX = 500 – 500 × ε 0 = 500 – 500 × ε ε = 1. b. Doing the same analysis with the new value of government spending we find: S = Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250 = 500 I = 1,000 – 50 × 5 = 750 NX = S – I = 500 – 750 = –250 NX = 500 – 500 × ε –250 = 500 – 500 × ε ε = 1.5. The increase in government spending reduces national saving, but with an unchanged world real interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciate. 34 Answers to Textbook Questions and Problems

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c. Repeating the same steps with the new interest rate, S = Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750 I = 1,000 – 50 × 10 = 500 NX = S – I = 750 – 500 = 250 NX = 500 – 500 × ε 250 = 500 – 500 × 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. 3. a. When Leverett’s exports become less popular, its domestic saving Y – C – G does not change. This is because we assume that Y is determined by the amount of cap- ital and labor, consumption depends only on disposable income, and government spending is a fixed exogenous variable. Investment also does not change, since investment depends on the interest rate, and Leverett is a small open economy that takes the world interest rate as given. Because neither saving nor investment changes, net exports, which equal S I , do not change either. This is shown in Figure 5–6 as the unmoving S – I curve. The decreased popularity of Leverett’s exports leads to a shift inward of the net exports curve, as shown in Figure 5–6. At the new equilibrium, net exports are unchanged but the currency has depreciated. Even though Leverett’s exports are less popular, its trade balance has remained the same. The reason for this is that the depreciated currency provides a stimulus to net exports, which overcomes the unpopularity of its exports by making them cheaper. Chapter 5 The Open Economy 35 S – I NX ( ε ) 1 NX ( ε ) 2 NX 1 = NX 2 { NX Net exports ε 1 ε 2 ε Real exchange rate Figure 5–6
There are also important compositional effects of this policy. On the production side, the higher exchange rate increases imports and puts pressure on the sales of American com-

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## This note was uploaded on 10/04/2011 for the course ECON 101b taught by Professor Staff during the Spring '08 term at University of California, Berkeley.

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HW3_sol - 34 Answers to Textbook Questions and Problems 2....

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