Question

Consider the following Neoclassical model of economy, where the domestic
interest rate r and the world interest rate r * are in percentage terms. 20 (Marks)
Supply: Y= 2000
NX= 200-200
r * = 5%
Demand: C = 200+ 0.8 (Y-T)
I= 400- 20r
G= 0, T = 0
(a) Find the equilibrium real interest, national saving, and investment in a closed
economy with no public sector. Show the equilibrium real interest rate on a
saving-investment diagram with r measured on the vertical axis.
(b) Now assume the small economy opens up to trade. Calculate the real exchange
rate, trade balance and net capital outflow. Show the trade balance on a
savings-investment diagram with measured on the vertical axis.

Answer 1

(a) Find the equilibrium real interest, national saving, and investment in a closed economy with no public sector. Show the equilibrium real interest rate on a saving-investment diagram with r measured on the vertical axis.

Y = C + I

Y= 2000

C = 200+ 0.8 (Y-T)

I= 400- 20r

T = 0

2000 = 200+ 0.8 (Y-T) + 400 - 20r + 0

2000 = 200+ 0.8 (2000 - 0) + 400 - 20r + 0

2000 = 200+ 1600 + 400 - 20r

2000 = 2200 - 20r

20r = 200

r = 10

Equilibrium real interest rate = 10

Investment in the closed economy

I = 400 - 20r

I = 400 - 20*10

I = 400 - 200

I = 200

National saving in the closed economy

National saving = National Income - Consumption

National saving = 2000 - {200 + 0.8 (Y-T)}

National saving = 2000 - {200 + 0.8 (2000 - 0)}

National saving = 2000 - {200 + 1600}

National saving = 2000 - 1800

National saving = 200

National savings is not dependent on Interest rate. Therefore, it is a constant.

(b) Now assume the small economy opens up to trade. Calculate the real exchange rate, trade balance and net capital outflow. Show the trade balance on a savings-investment diagram with measured on the vertical axis.

Net Export = Export - import = 200 - 200 = 0

Investment in the open economy depends on world interest rate r *

Investment = 400 - 20*5 = 400 - 100 = 300

Trade Balance = Net capital outflow = Saving - Investment = 200 - 300 = -100

When S < I, country is a net borrower

In the open economy the exogenous world interest rate determines investment and the difference between saving and investment determines net capital outflow