Economics 302 Spring 2008 Answers to Homework 3 Homework will be graded on completeness and content as well as neatness Sloppy or illegible work will not receive full credit This homework requires the use of Microsoft Excel If your answer requires rounding round to two decimal places 1 Small Open Economy Use the following set of Classical Model equation for a small open economy to answer the following questions Y F K L AK L1 C C Y T 23 72 Y T I I r 325 15 5 r Where r is expressed as a percentage i e if the interest rate is 5 then r 5 in the equation Y C I G NX Y C SP T G 220 T 155 K 1000 L 8000 A 0 3 Capital s Share of Income 1 3 a What is aggregate output Y for this economy Y AK L1 0 3 10001 3 80002 3 0 3 10 400 1200 b What is the level of consumption C for this economy C 23 72 Y T 23 0 72 1200 155 775 4 c What is the level of investment I for this economy if the world real interest rate r is 7 I I r 325 15 5 r 325 15 5 7 216 5 d Given the information you have found in parts a c find the level of net exports for this economy NX Y C I G 1200 775 4 216 5 220 11 9 NX NS I SP SG I Y C T T G I 1200 775 4 155 155 220 216 5 1 269 6 65 216 5 11 9 e Is this country borrowing from or lending to foreigners What is the relationship between domestic spending and domestic production in this economy and how do these two topics relate to one another Spending C I G in this economy exceeds domestic production Y This results in imports exceeding exports and the necessity of this economy borrowing from abroad These two questions get at the same relationship if you import more than you export you must be borrowing from foreigners to finance the extra purchases f Suppose government spending increases by 25 What are the effects of the increased government spending on output consumption investment and net exports in this economy Y 1200 K A L and are all constant C 775 4 Y and T are constant I 216 5 world real interest rate does not change with small economy SP 269 6 the same as Y C and T remain the same SG T G 155 245 90 25 less than before NX 36 9 25 less than before as I and Sp remained the same g Did the increase in government spending completely crowd out investment spending as it would have in a closed economy Explain your answer No there is no change in investment spending in the open economy as a result of the increase in government spending In the closed economy we would have seen a complete crowding out of investment spending with the increase in government spending The increase in government spending causes a decrease in public saving This in turn reduces the level of national saving This leads to more imports and more capital flowing into this economy The trade balance falls and we arrive at a new equilibrium h What happens to this country s real exchange rate when government spending increases holding everything else constant Explain your answer Will foreign or domestic goods become more attractive with the change in the real exchange rate The increase in government spending causes national saving to decrease which results in a shift left in the NCO NS I line and a higher real exchange rate for the economy This economy will find its exports less attractive to other economies as their currency increases in value relative to other currencies so they will export less On the other hand foreign goods become more attractive as they are now cheaper and imports will increase 2 i Assume that the Money Supply for this small open economy is 300 and that the velocity of money is 6 If the real exchange is 3 US goods for each domestic good and the price level in the US is 2 25 then what is the nominal exchange rate between this country and the US Using the quantity theory of money we know that Mv PY 300 6 1800 P 1200 P 1 5 Real Exchange Rate RER e P P RER 3 US domestic goods e 1 5 2 25 e 2 3 e 4 5 domestic currency 2 Small Economy Different Proposed Policies A small economy which historically has been closed to capital flows and trade is holding a democratic election for the very first time There are three candidates for president each with different proposed domestic and foreign policies Assume the small economy can be described by the set of equations below Y 6000 SP SP r Y T 1 100 16 375r 0 25 Y T I I r 2 000 250 r Where r is expressed as a decimal i e if the interest rate is 5 then r 0 05 in the equation r 0 08 is the world real interest rate Y C I G Currently in the Closed Economy Y C I G NX Proposed by some candidates in a Open Economy Y C SP T The first candidate 1 believes that the economy should remain a closed economy the government should have a balanced budget and that the government should collect 250 in taxes The second candidate 2 believes that the country should allow imports and exports the government should have a balanced budget and that the government should collect 500 in taxes The third candidate 3 believes that the country should allow imports and exports that the government should collect 300 in taxes and that the government should spend 500 For each of the following questions evaluate the proposed policies by each of the presidential candidates a For each presidential candidate what would be the level of public saving if their proposed policies were enacted Candidate 1 Balanced Budget implies T G implies SG 0 Candidate 2 Balanced Budget implies T G implies SG 0 Candidate 3 SG T G 300 500 200 3 b For each presidential candidate what would be the level of private saving if their proposed policies were enacted Candidate 1 Closed economy implies that NS I in equilibrium NS SP SG SP I SP 1 100 16 375r 0 25 6000 250 1 100 16 375r 1437 5 337 5 16 375r I 2 000 250 r SP 337 5 16 375r 2 000 250 r I 16 625r 1662 5 implies r 0 1 or 10 in equilibrium SP 337 5 16 375 0 1 337 5 1 637 5 1 975 Candidate 2 Open economy implies that world real interest rate will be the equilibrium interest rate r r T 500 SP 1 100 16 375 0 08 0 25 6000 500 1 100 1 310 1 375 1 585 Candidate 3 Open economy implies …