Consider an economy described by the following equations: Y = C + I + G + NX Y =
ID: 1105390 • Letter: C
Question
Consider an economy described by the following equations: Y = C + I + G + NX Y = 5,000 G = 1,000 T = 1,000 C = 250 + 0.75 (Y – T) I = 1,000 – 50 r NX = 500- 500 r = r* = 5 In this economy, solve for national saving, investment, the trade balance and the equilibrium exchange rate. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance and the equilibrium exchange rate. Explain what you find. Now suppose that the world interest rate rises from 5 to 10 percent (G is again 1,000). Solve for national saving, investment, the trade balance and the equilibrium exchange rate. Explain what you find.
Explanation / Answer
Given Y= C+I+NX = 5,000; G=1,000; T= 1,000; C=250+0.75(Y-T), I= 1,000-50r,; NX=500-500e & r=r*=5
In an economy,
National Savings= S = Public Savings + Private Savings
Private Savings = Y-T-C = 5,000-1,000-(250+0.75(5000-1000)= 750
Public Savings= T-G= 1,000-1,000 = 0
therefore, National Savings = 750+0 = 750
Investment (I)= 1,000- 50r = 1,000- 50 * 5 = 7,50
Trade Balance = NX = S-I = 750- 7,50= 0
The Equilibrium exchange rate(e), NX = 500 - 500e
i.e., 500-500e = 0 i.e., e = 1
Again if G rises to 1,250 then
National Savings = Y-T-C + (T-G) = Y-C -G = 5,000-3250 - 1250 = 5000- 4500= 500
Investment = (I) = 1,000- 50r = 1,000- 50 * 5 = 750
Trade Balance = Total Savings- Investment = S- I= 500- 750 = -250
Equilibriium exchange rate (e),
500-500e = NX = -250 i.e., e = 1.5
Again if G remains unchanged at 1,000 then national savings = S= Y-T-C +T-G =Y-C-G= 5000-3250-1000= 750
Investment = I = 1000- 50r = 1000-50*10 as rate of interest r = 10 in this case
i.e., I = 500
The trade balance (NX) = National Savings - Investment = 750-500= 250
Equilibrium exchange rate (e )
NX = 500-500e
i.e., 250=500-500e i.e., e = 250/500= 0.5
From the above analysis we find that national savings remains unchanged when rate of interest changes whereas when G changes National savings, trade balance and equilibrium exchange rate also changes.