Question

Tenement Yaard is a small open economy described by the following long-run classical equations where Y is the economy's real GDP, T-taxes, G- government spending, NX - net exports, I- investment C- consumption, r- domestic interest rates, r*- world interest rates:

Y= C + I + G + NX

Y = 6000

G = 1000

T = 1000

C = 300 + 0.8 (Y-T)

I = 2000 - 50r

NX = 500 - 400e

r = r* = 4

a. Find the national saving, investment, trade balance and the equilibrium exchange rate.

b. The government spending of Tenement Yaard rises to 1400. Compute the investment, trade balance, national savings and the equilibrium exchange rate.

Explain what you find compared to part (a) and illustrate graphically.

c. Now suppose that the world interest rate rises from 4 to 8 percent (G is again 1000). Solve for national saving, investment, trade balance and the equilibrium exchange rate.

Explain what you find compared to part (a) and illustrate graphically.

Answer 1

(a)

(i)

C = 300 + 0.8(6000 - 1000) = 300 + 0.8 x 5000 = 300 + 4000 = 3400

National saving = (Y - C) + (T - G) = (6000 - 3400) + (1000 - 1000) = 2600

(ii)

I = 2000 - 50 x 4 = 2000 - 200 = 1800

(iii)

Trade balance (NX) = Y - C - I - G = 6000 - 3400 - 1800 - 1000 = - 200

(iv)

NX = 500 - 400e

- 200 = 500 - 400e

400e = 700

e = 1.75

(b)

C = 300 + 0.8(6000 - 1000) = 300 + 0.8 x 5000 = 300 + 4000 = 3400

National saving = (Y - C) + (T - G) = (6000 - 3400) + (1000 - 1400) = 2200 (National saving decreases by 400)

(ii)

I = 1500 - 60 x 3 = 1500 - 180 = 1320 (Investment stays the same)

(iii)

Trade balance (NX) = Y - C - I - G = 6000 - 3400 - 1800 - 1400 = - 600 (Trade balance decreases by 400)

(iv)

NX = 500 - 400e

- 600 = 500 - 400e

400e = 1100

e = 2.75 (Exchange rate increases by 1)

Increase in government spending will decrease national savings. The savings curve shifts leftward, increasing interest rate and decreasing equilibrium saving and investment.

As interest rate increases, net capital outflow decreases, which decreases net exports (trade balance) and increases exchange rate.

In following graph, panel A shows saving (S) and investment (I) curves. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

As savings decrease, S0 shifts left to S1, intersecting I0 at point B with higher interest rate r1 and lower quantity of saving and investment Q1.

In panel B (showing net capital outflow as inverse function of interest rate), higher interest rate from r0 to r1 decreases net capital outflow from NCO0 to NC01.

In panel C (showing net exports as inverse function of exchange rate), a decrease in net capital outflow from NCO0 to NCO1 decreases net exports from NX0 to NX1 and increases exchange rate from e0 to e1.

(c)

(i)

C = 300 + 0.8(6000 - 1000) = 300 + 0.8 x 5000 = 300 + 4000 = 3400

National saving = (Y - C) + (T - G) = (6000 - 3400) + (1000 - 1000) = 2600 (National saving stays the same)

(ii)

I = 2000 - 50 x 8 = 2000 - 400 = 1600 (Investment decreases by 200)

(iii)

Trade balance (NX) = Y - C - I - G = 6000 - 3400 - 1600 - 1000 = 0 (Trade balance increases by 120)

(iv)

NX = 500 - 400e

0 = 500 - 400e

400e = 500

e = 1.25 (Exchange rate decreases by 0.5)

Decrease in investment will shift the investment curve leftward, decreasing interest rate and decreasing equilibrium saving and investment.

As interest rate decreases, net capital outflow increases, which increases net exports (trade balance) and decreases exchange rate.

In following graph, panel A shows saving (S) and investment (I) curves. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

As investment decreases, I0 shifts left to S1, intersecting I0 at point B with lower interest rate r1 and lower quantity of saving and investment Q1.

In panel B (showing net capital outflow as inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C (showing net exports as inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and dencreases exchange rate from e0 to e1.