Homework 4-
1. Consider the following economy.
The business sector has an investment function: r = 10 - I/4000
The household sector has a saving function: r = -5 + Sp/1000
I is the level of investment, r is the interest rate in percentage terms and SP is the level of private saving.
a) Write an equation expressing GDP, or Y, for this economy. Assume this is an open economy and that there are four sectors that demand goods and services in this economy. Then, solve this equation for investment. (Hint: at this point you are not using any numbers; you are only using symbols.)
b) Write an equation for private saving, SP.
c) Write and equation for public saving, SG.
d) Write an equation for National Saving, NS, that indicates the all the components of NS.
e) In equilibrium we know that investment equals national saving and capital inflows. Using the equations you have in parts (a) through (d), provide a proof that this is true.
f) Suppose that government saving in this economy is equal to zero. Furthermore, assume initially that this economy is not trading with other countries (hence, capital inflows equal 0 and X - M = 0).Graph the demand and supply for loanable funds and find the equilibrium interest rate, the equilibrium level of investment, the equilibrium level of private saving and the equilibrium level of national saving.
g) Now the government decides to save 5 thousand dollars (SG = 5000). Graph the demand and supply for loanable funds and find the new equilibrium interest rate, the equilibrium level of investment, the equilibrium level of private saving and the equilibrium level of national saving.
h) How does the government's decision to save affect the equilibrium level of investment and the equilibrium level of private saving?
i) Suppose this country now begins to trade with other countries and it finds with this trade that it now has capital inflows of 5 thousand dollars. Assume that the government is still saving 5000 dollars. Find the new equilibrium interest rate, the new equilibrium level of investment, the new equilibrium level of private saving and the new equilibrium level of national saving.
j) How does this capital inflow affect the equilibrium level of investment and the equilibrium level of private saving?
2. Consider the following economy.
Suppose that you have observed the following components of GDP for a small open economy.
GDP = 50,000
C = 25,000
G = 10,000
X = 10,000
M = 15,000
a) Find the equilibrium level of investment.
In addition, you have observed the behavior of business investment and private saving as follows (for this problem assume that the investment schedule and the private saving schedule are both linear):
|
r
|
I
|
Sp
|
|
10
|
5,000
|
40,000
|
|
2
|
29,000
|
8,000
|
b) Find the equilibrium interest rate.
c) Find the equilibrium level of private saving.
d) Find the equilibrium level of net taxes (T-TR)
3. Imagine that you are a Classical Economist. Briefly answer the following questions.
a) What is the role of aggregate demand in the economy?
b) What are the main sources of economic growth?
c) Explain Say's Law.
d) Why is the Classical Model referred to as a long-run economic model?
e) What is the role of the government in the Classical Model?
4. What do you think a Classical Economist would say to the following statements?
a) An owner of a firm makes an statement in the Business Section of the local newspaper that states "My factory produces too many cars so it is impossible to sell all of them."
b) The government issues a statement about the state of the economy that states "The economy is in recession, we should increase our spending (G)."
c) At the community meeting a poor worker states "I can't find a job!"
d) A local consumer asks you, his financial advisor, the following question: "If I want to help the economy, should I spend on consumption goods or should I save?"