Question

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Equilibrium in the Classical model: Consider an economy described by the following equations: Y = C...

Equilibrium in the Classical model: Consider an economy described by the following equations:

Y = C + I + G

Y = 12,000

G = 2,000

T = 2,000

C = 500 + 0.75*(Y – T)

I = 2,400 – 80*r

a) In this economy, compute private saving, public saving, and national saving.

b) Find the equilibrium real interest rate r.

c) Now suppose that G rises to 1,200. Compute private saving, public saving, and national saving in this case.

d) Find the new equilibrium real interest rate.

Expert Solution

a) In this economy, compute private saving, public saving, and national saving.

Private saving = Y - T - C = 12000 - 2000 - 500 - 0.75*(12000 – 2000) = 2000

Public saving = T - G = 2000 - 2000 = 0

National saving = Public saving + private saving = 2000

b) Find the equilibrium real interest rate r.

Y = C + I + G

12000 = 500 + 0.75*(12000 – 2000) + 2400 – 80*r + 2000

12000 - 12400 = -80r

Equilibrium interest rate = 400/80 = 5%

c) Now suppose that G rises to 1,200. Compute private saving, public saving, and national saving in this case.

When G is increased by 1200, income does no rise in Classical case so Y is 12000.

Private saving = Y - T - C = 12000 - 2000 - 500 - 0.75*(12000 – 2000) = 2000

Public saving = T - G = 2000 - 3200 = -1200

National saving = 2000 - 1200 = 800

d) Find the new equilibrium real interest rate.

12000 = 500 + 0.75*(12000 – 2000) + 2400 – 80*r + 3200

12000 - 13600 = 80r

Equilibrium interest rate rises to = 1600/80 = 20%

Rahul Sunny answered 2 years ago

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