Question

Consider an economy described by the following equations Y = C + I + G Y=4,000 G= 1,000 T=800 C =400 + 0.75(Y–T) I = 1,000–50r(a) For this economy, compute the following [1.5 Points each; 6 Points total]1. Private Savings2. Public Savings3. National Savings4. Equilibrium interest rate

(b) Is this economy running a budget surplus, budget

deficit or a balanced budget? Explain.

[2 Points]

(c) Suppose that

Congress

decides to reduce government spending.

The new level of government spending is now G=800 Assume all other variables are held constant. Compute the following variables after this falling government spending

1. Private Savings

2. Public Savings

3. National Savings

4. Equilibrium interest rate

(d)

Graphically illustrate the increase of consumer confidence on

the Savings- Investment diagram. Be sure to clearly label your curves and the axis. In

your graph, clearly indicate any shifts of curves and equilibrium points.

Answer 1

a) Putting the values of Y,C,I,T and G in the given equation Y=C+I+G

or, Y=400+0.75(Y-T)+I+G

or, 4,000=400+0.75(4,000-800)+1,000-50r+1,000

or, 4000=400+2400+1000+1000-50r

or, 50r=4,800-4,000

or, 50r=800

or, r = 16% is the equilibrium interest rate.

Now, Public savings = T-G = 800-1,000 = -200

and Private savings = Y-T-C = 4,000-800-(400+0.75(4,000-800)) = 4,000-800-400-2,400 = 400

Then, National savings = Public savings+Private savings = -200+400 = 200

b) Here, the economy is running a budget deficit because government expenditure G is greater than taxes T.

Budget deficit = G-T = 1,000-800 = 200

c) If G is reduced to 800,

Then, Y=C+I+G

or, Y=400+0.75(Y-T)+I+G

or, 4,000=400+0.75(4,000-800)+1,000-50r+800

or, 4,000=400+2,400+1,000+800-50r

or, 50r=4,600-4,000

or, 50r=600

or, r=12% is the equilibrium interest rate

Now, Public savings = T-G=800-800 =0

and Private savings = Y-T-C = 4,000-800-(400+0.75(4,000-800)) = 400

Thus, National savings = Public savings + Private savings = 0+400 = 400

d) In the diagram below, we have shown the effects of increase in consumer confidence on Savings-Investment diagram :

Here, we have plotted rate of interest on the Y-axis and Savings , Investment on the X-axis.With increase in consumer confidence, consumers tend to spend more (consume) and save less. As a result, the savings curve shifts to the left to Savings 2. Now, with shift in savings curve, new equilibrium is attained at the point where National Savings = Investment. This causes rate of interest to rise and Savings and Investment to fall.