Question

Assume that GDP (Y) is 7,500, which is also the full employment level of real GDP. Consumption (C) is given by C = 700 + 0.75(Y – T). Investment (I) is given by the equation I = 2000 – 200r, where r is the rate of interest in percent. Taxes (T) are 500 and government spending (G) is 500. The world interest rate (r*) is equal to 4 percent.

Use the data above to calculate:

Consumption =   and National Saving =

Assuming domestic firms can borrow or lend as much as they want at the world rate of interest, Investment =  . Therefore, net foreign investment =  and net exports =   .

Do these numbers imply that this country is a net lender or a net debtor?    

Do these numbers imply that this country has a trade surplus or a trade deficit?  

If government uses an expansionary fiscal policy, will the national saving function shift right or left?

Will the change in national saving resulting from an expansionary fiscal policy cause net exports to increase or decrease?  

Answer 1

(a) We shall find consumption, national savings and net exports in following way:

• We find consumption level by substituting values of Y and T in the consumption function.
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• The national saving can be calculated using following identity:
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• We are provided that domestic firm can lend or borrow as much it can at world interest rate of 4%. There investment in the economy would be:
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• Net foreign investment equals the amount that foreigners invest in the domestic country minus the amount that domestic country residents invest abroad. Net foreign investment generally equals net exports.
  • Gross foreign investment + Imports = Gross foreign savings + Exports.
  • GFI - GFS = X-M
  • Net foreign investment = Net exports.
  • Using National income identity.
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• The negative value implies we must be borrowing from the foreign countries. Therefore, country is Net Debtor.
• The negative value implies that imports exceed exports. This means country is running Trade Deficit.

(b) The expansionary fiscal policy may involve increase in the government expenditure or reduction in the taxes. The policy is aimed to boost consumption and reduce unemployment in the economy.

• Now, we must know that government will borrow from the public for an amount equal to the government expenditure.
• This government expenditure will raise budget deficit and cause decline in the public savings. This implies that National savings will fall with rise in G. (It involves leftward shift of the savings function)
• Using above identity, we can gauge that net exports will decline with fall in the national savings.