Ch. 5 - ECN101 Intermediate Macroeconomics Professor...

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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Homework 5-Solutions (3) Next, using the saving and investment graphs that we have developed in lecture for the small open economy, begin with a small trade deficit (S less that I at the global real interest rate R*) and trace through the impact of the following: a) Cut in domestic taxes b) Rise in the domestic marginal propensity to consume (MPC) c) Fall in the demand for domestic investment d) Rise in the demand for domestic investment e) A cut in the taxes of the major economies in the rest of the world (ROW). f) A slowdown in the demand for imports from the major economies in the rest of the world. g) A sudden drop in savings by the economies in the ROW. By the end of this course you will be able to use this graph to trace through the impact of just about anything that can affect the international position of the macro-economy, e.g., domestic money supply shift, credit rationing, the election of a democratic or republican president, threats of nuclear proliferation in Asia, a missive hike in oil prices, etc. SOLUTIONS: In the model of small open economy, we derive the trade balance from national income identity as () [] () () NFI r I S r I G T Y C Y NX = = = * * The total output Y is assumed fixed in this model; consumption C is positively related to disposable income (Y-T) and marginal propensity to consume (MPC); investment I is negatively related to the world real interest rate r*. S-I is called net capital outflow, or net foreign investment position, denoted by NFI. a) Cut in domestic taxes A cut in domestic taxes raises disposable income ( ) T Y , stimulates consumption C. The increase in C reduces national saving, because ( ) G Y S T Y C = . With an unchanged world real interest rate, investment remains the same. Therefore, the net foreign investment decreases. Because NX=S-I, the trade balance decreases as well. Since we begin with a small trade deficit, after the cut in domestic tax, the economy’s trade deficit becomes even bigger. I S
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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Figure 1 r 1 * S 1 NX 2 <0 NX 1 <0 S 2 I(r) I, S Real interest rate, r b) Rise in the domestic marginal propensity to consume (MPC) A rise in the MPC will increase consumption C because MPC measures the amount by which consumption changes when disposable income increases by one dollar. The increase in C reduces national saving, because ( ) G T Y C Y S = . With an unchanged world real interest rate, investment remains the same. Therefore, the net foreign investment decreases. Because NX=S-I, the trade balance decreases as well. See figure 1. I S c) Fall in the demand for domestic investment A fall in the demand for domestic investment shifts the investment demand schedule down, from I 1 to I 2. Thus domestic investment decreases even when the world interest rate
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Ch. 5 - ECN101 Intermediate Macroeconomics Professor...

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