Week 8 Tutorial Questions Solutions (Ch5)

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1 Chapter 5: Q1: Macroeconomics P.177 Numerical Problems #1 Q2: Macroeconomics P.177 Numerical Problems #3 Q3: Macroeconomics P.178 Numerical Problems #5 Q4: Macroeconomics P.179 Analytical Problems #5 Q1: Here are some balance of payments data (without pluses and minuses): Merchandise exports, 100 Merchandise imports, 125 Service exports, 90 Service imports, 80 Investment income receipts from assets, 110 Investment income payments on assets, 140 Transfers from home country to other countries, 10 Increase in home country s ownership of assets abroad, 160 Increase in foreign ownership of assets in home country, 200 Increase in home reserve assets, 30 Increase in foreign reserve assets, 35 Find the merchandise trade balance, net exports, the current account balance, the capital account balance, the official settlements balance, and the statistical discrepancy. Merchandise trade balance = = -$25 Net export = X IM = ( ) ( ) = -$15 CA balance = ( ) ( ) = -$55 KA balance = = $40 (Notice that the increase in home reserve assets is just a subcategory of the increase in home country assets, so it is not included separately. Similarly, the increase in foreign reserve assets is just a subcategory of the increase in foreign assets in the home country. The information about the changes in home and foreign reserve assets is included in the calculation of the official settlements balance only; it does not affect the capital account. Refer to textbook example P.147 Table 5.1) Official settlement balance = = -$5 Week 8 Page 1

2 Statistical discrepancy (SD): CA + KA + SD = SD = 0 SD = 15 Q2: In a small open economy, Desired national saving, S d = $10 billion + ($100 billion) r w Desired investment, I d = $15 billion ($100 billion) r w Output, Y = $50 billion Government purchases, G = $10 billion World real interest rate, r w = 3% a) Find the economy s national saving, investment, current account surplus, net exports, desired consumption, and absorption. S d = 10 + ( ) = $13 I d = 15 (100 x 0.03) = $12 NX = CA = S d I d = = $1 C d = Y (I + G + NX) = 50 ( ) = $27 Absorption = C + I + G = = $49 b). Owing to a technological innovation, the country s desired investment rises by $2 billion at each level of the world real interest rate, repeat part (a). S d = 10 + ( ) = $13 I d = 17 ( ) = $14 NX = CA = S d I d = = $1 C = Y (1 + G + NX) = 50 ( ) = $27 Absorption = C + I + G = = $51 Week 8 Page 2

3 Q3. Consider a world with only two countries, which are designated the home country (H) and the foreign country (F). Output equals its full-employment level in each country. You are given the following information about each country: Home country Consumption: Investment: C H = Y H 500r I H = r Government purchases: G H = 155 Full-employment output: Y H = 1000 Foreign country Consumption: Investment: C F = Y F 600r I F = r Government purchases: G F = 190 Full-employment output: Y F = 1200 a). write national saving in the home country and in the foreign country as functions of the world real interest rate r. S H = Y H - C H G H = 1000 [100 + ( ) 500r] 155 = r S F = Y F C F G F = 1200 [225 + ( ) 600r] 190 = r b). what is the equilibrium value of the world real interest rate? NX H = S H - I H = r ( r) = r NX F = S F - I F = r ( r) = r In equilibrium, one country s CA surplus should equal to the other country s CA deficit, thus we have: NX H + NX F = 0, so r + ( r) = r = 360 r = 0.20 Week 8 Page 3

4 c). what are the equilibrium values of consumption, national saving, investment, the current account balance, and absorption in each country? C H = ( ) ( ) = 500 S H = ( ) = 345 I H = 300 ( ) = 200 CA H = NX H = ( ) = 145 (assume NFP = 0) Absorption H = C H + I H + G H = = 855 C F = ( ) ( ) = 945 S F = ( ) = 65 I F = 250 ( ) = 210 CA F = NX F = ( ) = 145 (assume NFP = 0) Absorption F = C F + I F + G F = = 1345 Q4: How would each of the following affect national saving, investment, the current account balance, and the real interest rate in a large open economy? a). An increase in the domestic willingness to save (which raises desired national saving at any given real interest rate). The home country's saving curve shifts to the right, from S 1 to S 2. The real world interest rate falls, so that the current account surplus in the home country equals the current account deficit in the foreign country. S rises, I rises, CA rises, r w falls. Week 8 Page 4

5 b). An increase in the willingness of foreigners to save. The foreign country's saving curve shifts to the right, from S 1For to S 2For The real world interest rate must fall, so the current account surplus in the foreign country equals the current account deficit in the home country. As shown in the figure, S falls, I rises, CA falls, r w falls. c). An increase in foreign government purchases. The foreign country's saving curve shifts to the left, from S 1For to S2For. The real world interest rate must rise, so the current account deficit in the foreign country equals the current account surplus in the home country. As shown in the figure, S rises, I falls, CA rises, r w rises. Week 8 Page 5

6 d). An increase in foreign taxes (consider both the case in which Ricardian equivalence holds and the case in which it does not hold). If Ricardian equivalence holds, there is no effect. If Ricardian equivalence does not hold, then the result is the same as in part b, as the foreign country's saving curve shifts to the right. Week 8 Page 6

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