ECON 201 Principles of Macroeconomics Fall 2009 Name ____________________________ S I KI Exercises Define Saving Saving rate Public saving Government budget deficit (Fiscal) Crowding out (of Investment) Investment Real interest rate Capital inflow Trade surplus 1. Explain, givin g the economic intuition, the signs of the slope of each line. That is, a. What is the economic reason for a positive relation between S and r? That is, why do people choose to give up consumption if the real interest rate is higher? b. What is the economic reason for a positive relation between I and r? That is, why do firms buy more capital goo ds if the real interest rate is lower? c. What is the economic reason for a positive relation between KI and the difference between r and rworld? That is, why do people locate their funds in a country rather than in another country depending on (r – rworld)? 2. Identify the following equations: This equation I = 1000 – 5000 r is the _____________________equation This equation S = –250 + 3500 r is the _____________________equation This equation KI = 5000 (r – rworld) is the _____________________equation 3. Using algebra, solve the above system of equations. Assume that rworld =5%. Using algebra, find the value of S = ____________ __, I = _______________, KI= ____________, r = ____________. Actually, this system is impossible to solve! We have three equations and 4 unknowns (I, S, KI, and r). So we need a fourth equation, an equilibrium condition, (which you would do very well to memorize) I = S + KI Using the fourth equation, and the fact that rworld =5%, we can get 1000 – 5000 r = (–250 + 3500 r) + 5000 (r – 0.05) Solving that one equation for the one remaining unkn own, r, gets us the answer for the real interest rate. 5000 r + 3500 r + 5000 r = 1000 + 250 + 5000 (0.05) 13500 r = 1500 r = 11.11% Plugging the result for r into the I function gives us the value of I, and the same for the values of S and KI. I = 1000 – 5000 r = 1000 – 5000 *0.1111 = 444.44 S = –250 + 3500 r = –250 + 3500 *0.1111 = 138.88 KI = 5000 (r – rworld) = 5000 (0.1111 – 0.05) = 305.55 S+KI = 444.44 The situation is illustrated on this graph. 4. Suppose an increase in government spending reduces national saving at every level of the interest rate by 500, so that now S = –750 + 3500 r. Find the new values of S = ______________, I = _______________, KI= ____________, r = ____________. a. Show first what happens with algebra. b. Show what happens in the graph. 5. Suppose that a financial crisis reduces business confidence, reducing investment at every level of the interest rate, so that now I = 750 – 3000 r. Find the new values of S = ______________, I = _______________, KI= ____________, r = ____________. a. Show first what happens with algebra. b. Show what happens in the graph. 6. Suppose that a revolution increases the perception of country riskiness by foreigners, so that capital inflows decline at every level of the interest rate. This means that KI = – 100 + 5000 (r – rworld). Find the new values of S = ______________, I = _______________, KI= ____________, r = ____________. a. Show first what happens with algebra. b. Show what happens in the graph. 0%5%10%15%20%25%‐200 ‐100 0 100 200 300 400 500I S+KI7. Suppose that the world interest rate increases, so that capital inflows decline at every level of the domestic interest rate (this is what happened to Mexico in 1982). This means that KI = 5000 (r – 0.20). Find the new values of S = ______________, I = _______________, KI= ____________, r = ____________. a. Show first what happens with algebra. b. Show what happens in the graph. 8. Suppose that the country closed itself to the rest of the world, so KI = 0. This means that in equilibrium I=S, investment must be fully financed by national saving. Find the new values of S = ______________, I = _______________, KI= 0, r = ____________. a. Show first what happens with algebra. b. This is illustrated in this graph. Openness to capital inflows exposes a country to ma ssive changes in interest rates, which can be incredibly damaging to a country’s political, social, and economic stability and development. But closing the country ensures little investm ent and little growth. What do you think is a good solution? 0%5%10%15%20%25%‐200 ‐100 0 100 200 300 400 500I SExchange Rate Exercises • Demand of domestic currency o Exports  Increased preference for Home goods (shift of demand)  Increased in Foreign GDP (shift of demand)  Depreciation of the currency: DomCurr becomes cheaper & ForCurr is more valuable (movement along the demand curve) o Capital Inflows  Increase in Home interest rate (shift of demand)  Home country less risky (shift of demand) • Supply of domestic currency o Imports  Increased preference for Foreign goods (shift of supply)  Increase in Home GDP (shift of supply)  Appreciation of the currency: DomCurr becomes more expensive & ForCurr is less valuable (movement along the supply curve) o Capital outflows  Increase in Foreign interest rate (shift of supply)  Home country more risky (shift of supply) 1. A popular TV show increases foreigners’ demand for Domestic goods. a. Does this change the demand for DomCurr? Or does it change the supply of DomCurr? b. What happens to the q uantity, at any level of the exchange rate? That is, is this a movement to the right (more quantity) of the appropriate curve, or a movement to the left (less quantity) of the appropriate curve? c. Show the shift on the following graph: d. Then the economy is moving along the other curve. Does the market equilibrium exchange rate increase or decrease? D DomCurr S DomCurr # 1  Q DomCurr (solution: DomCurr should appreciate, that is, it should take more units of ForCurr to buy one unit of DomCurr. This makes sense: if our goods are more attractive to foreigners, our currency should gain value). 2. The Foreign country comes out of a recession. a. Does this change the demand for DomCurr? Or does it change the supply of DomCurr? b. What happens to the q uantity, at any level of the exchange rate? That is, is this a movement to the right (more quantity) of the