Question

In an imaginary closed economy, the market for loanable funds is in equilibrium in which the government is running a balanced budget. In equilibrium, GDP, consumption expenditure and government expenditure are $4,000 million, $2,500 million and $1,000 million, respectively.

a. Calculate private saving, public saving, taxes and investment.

b. In order to finance for additional expenditures in the future, suppose the government is running a budget deficit in which it raises fund through selling government bonds in the open market. Explain the effects of this policy on the real interest rate and investment.

c. If the imaginary economy is a closed economy, what is the relationship between domestic investment and national saving?

d. If the imaginary economy has a reform, and then changes to an open economy, what is the new relationship between domestic investment and national saving?

Answer 1

There is a balanced budget so G = T. In equilibrium, GDP = 4000, C = 2500 and G = 1000 all in million.

a. Use the formula

GDP = C + I + G

4000 = 2500 + I + 1000

Investment = 500 million

Private saving = Investment because public saving is 0 = 500 million

Public saving = 0 million because there is a balanced budget.

Taxes = 1000 million because there is a balanced budget so T = G

b. Now the government is running a budget deficit and it raises fund through selling government bonds in the open market. This will increase the supply of bonds in bond market and increase the demand for funds in loanable funds market. As a result, demand curve shifts to the right, raising the real interest rate and consequently reducing the level of investment.

c. If the imaginary economy is a closed economy, domestic investment and national saving are always equal to each other because there are no trade flows so whatever is saved is invested domestically.

d. If the imaginary economy has a reform, and then changes to an open economy, we could see that saving - investment = current account balance or saving - investment = net exports.