# UW-Madison ECON 302 - Answer Key (3 pages)

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- Pages:
- 3
- School:
- University of Wisconsin, Madison
- Course:
- Econ 302 - Intermediate Macroeconomic Theory and Policy

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Economics 302 Spring 2007 Answer Key Homework 3 1 a Y 2000 C 1375 S 2000 1375 700 75 Using the condition S I implies r 21 5 The graph is the standard one used in section national savings is a vertical line the investment demand function is linear downward sloping and crosses the y axis at I 1000 b In an open economy the domestic interest rate will equal the world interest rate The assumption needed to get this is that of perfect capital mobility Under perfect capital mobility and a world interest rate r domestic firms would never pay a domestic investor more than r since it could always get a cheaper loan on the international capital market At the same time a domestic investor would never lend to a firm at less than r since it could always lend its money to a foreign firm and earn return r Thus the equilibrium domestic interest rate with a small open economy must have r r The appropriate graph should demonstrate that it is the interest rate r 5 which is fixed first Given this you can find I r from the investment demand curve Compare this with national income S to get the trade balance c National savings will be S Y C G 75 Under the assumptions of our Classical model national savings is unaffected by the real interest rate d Given r 5 I 5 750 so I 750 75 S This means that the country is investing domestically more than it is saving domestically Thus capital must be flowing in from somewhere else Also NX S I 825 0 e A world war causes a significant fraction of world governements to spend more and save less run deficits Thus world savings falls Assuming that the world demand for investment is unchanged or perhaps increases then the world interest rate will increase The shock thus has the affect of moving Cowtopia s domestic interest rate to 10 as it was in part a Thus its trade balance is 575 So it is still negative just less so f In part d NX 825 250 250 so 4 3 In part e NX 575 250 250 so 3 3 2 a The natural rate of unemployment is s s f 4 76 b c and d see the

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