# HW2Answerkey - ECON 420-02 &amp; 04: Fall 2008 Homework 2...

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Homework 2 Due in class on September 17, 2008 1. In the country of Wiknam, the velocity of money is constant. Real GDP grows by 5% per year, the money stock grows by 14% per year, and the nominal interest rate is 11%. What is the real interest rate? (5 points) % Change in P = % change in M - % change in Y = 0.14-0.05=0.09 Real interest rate = 0.11 – 0.09 = 0.02 or 2% 2. Consider an economy described by the following equations: Y = C + I + G + NX Y = 5,000 G = 1,000 T = 1,000 C = 250 + 0.75 (Y-T) I = 1000-50r NX = 500-500ε r = r * = 5 a. In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate. (5 points) National Saving = Y-C-G = 5000-(250+0.75*(5000-1000)+1000)=750 Investment = 1000-50*0.05=750 Trade Balance = NX = Y-(C+I+G) = 5000-(250+0.75*(5000-1000)+750+1000)=0 0 = 500-500 ε; Thus equilibrium exchange rate = 1 b. Suppose now that G rises to 1,250. Solve for national saving, investment, and trade balance, and the equilibrium exchange rate. Explain what you find.(5 points) National Saving = (Y – C - G) = 5000-(250+0.75(5000-1000)-1250)=500 Investment = 750 Trade balance = S-I = 500-750 = -250 Equilibrium exchange rate : -250 = 500-500 ε Thus equilibrium exchange rate = 1.5 An increase in G with no change in other variables has to be financed by borrowing form abroad which is reflected by the current account deficit. The domestic currency depreciates as reflected by equilibrium exchange rate. c. Now suppose that the world interest rate rises from 5 to 10 percent (G is again 1,000). Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. (5 points) National Saving = Y-C-G = 5000-(250+0.75*(5000-1000)+1000)=750 Investment = 1000-50*0.10=500 Trade Balance = NX = Y-(C+I+G) = 5000-(250+0.75*(5000-1000)+500+1000)=250 250 = 500-500 ε; Thus equilibrium exchange rate = 0.50 Higher interest rates reduce investment spending resulting as well as reduce exchange rate. 1

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## This document was uploaded on 10/28/2011 for the course ECON 420 at UNC.

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HW2Answerkey - ECON 420-02 &amp; 04: Fall 2008 Homework 2...

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