Question

Use the following information about the closed economy of Vanatu to answer questions 7 and 8:

Y=$35,000
T=$5,000 C=MPC*(Y-T)+$1000-1,000r MPC=0.8
G=$6,500
I=$4000-2,000r

8. Now suppose that the government of Vanatu wants to increase spending on military services. Assume that government purchases increase by $1,500. At the same time, assume the inflation rate in Vanatu is, and remains, 10%. Then

1. a) The nominal interest rate now is 76.7%; private savings increases

2. b) The nominal interest rate now is 67.5%; private savings decreases

3. c) The nominal interest rate now is 33.2%; private savings increases

4. d) The nominal interest rate now is 43.3%; private savings decreases

5. e) The nominal interest rate now is 57.7%; private savings increases

THE ANSWER IS A I AM JUST CONFUSED HOW TO GET THERE

Answer 1

When economy is closed, equilibrium occurs when Y = C + I + G

Initial Income(Y) = 35000

Now G increases by 1500 => New G = 6500 + 1500 = 8000

=> 35000 = 0.8*(35000 - 5000) + 1000 - 1000r + 4000 - 2,000r + 8000

=> 35000 = 37000 -3000r

=> r = 2000/3000 = 0.667 = 66.7%

Hence Real interest rate = 66.7%

Nominal interest rate = Real interest rate + Inflation rate = 66.7% + 10% = 76.7%

Hence, Nominal interest rate = 76.7%

Private saving= Y - C - T

Y and T are same as before. Now lets compare C.

Initially G = 6500.

Thus we have Y = C + I + G => 35000 = 0.8*(35000 - 5000) + 1000 - 1000r + 4000 - 2,000r + 6500

=> r = (35500 - 35000)/3000 = 0.1667

Thus we can see from above that Because of Increase in G, r increases. As C is inversely related to r and hence C will decrease.

Thus Increase in G will result in decrease in C and thus Y - T - C will increase.

Hence, Saving will increase.

Hence the correct answer is (a) The nominal interest rate now is 76.7%; private savings increases.

(Also : as interest rate increases people will save more and consume less and thus Private saving will increase).