UWI CAVEHILL FACULTY OF SOCIAL SCIENCES DEPARTMENT OF ECONOMICS ECON2002 TOPIC 2

Question

UWI CAVEHILL FACULTY OF SOCIAL SCIENCES DEPARTMENT OF ECONOMICS ECON2002 TOPIC 2: Classical Macroeconomic Theory: Long Rurn Economic Performance TUUTORIAL 2- Classical Macroeconomic Model of a CLOSED Economy Reading: Chapter 3 - Mankiw 1. Solo nation has no relations with other countries. Its economy is described by the following cqualions Y=C+I+G Y = 5,000 G 1,000 T= 1,000 C = 250 + 0.75(Y-T) 1 = 1,000-50r where Y is total income (GDP). G is the government expenditure, T are the taxes, C is aggregate consumption that depends on disposable income (Y-T) and I is the investment function that we assume to be negatively related with the interest rate (r) a) From this economy. calculate private saving, public saving and national saving: b) Find the equilibrium interest rate; c) Now suppose politicians in Solo nation decide to increase G to 1500, everything else constant. Compute the private saving, public saving and national saving d) Find the new equilibrium interest rate. Comment your result. 2. The governments' of the world economy decides to raise taxes by 300 billion. Suppose their marginal propensity to consume is 0.75, what happens to the following? Do they rise or fall? By what amounts? a) The world's public saving. b) The world's private saving c) The world aggregate saving d) The world's investment. 3. Venus nation is trying to reduce its unsustainable budget deficit. As their newly appointed economist, Venus nation's prime minister has tasked you to write a detailed report showing and explaining the likely effects of increase in taxes to consumption, investment and interest rate. [Note: Graphs and equations should be included where necessary]

Explanation / Answer

Y = GDP

G = Government expenditure

T = Taxes

C = Aggregrate consumption

C = 250 + 0.75 (Y-T)

C = 250 + 0.75 (5000-1000)

C = 3250

1) a) Private savings = Y-T-C = 5000 - 1000 - 3250 = 750

National savings = Y-C-G = 5000-3250 - 1000 = 750

Public savings = T-G = 1000-1000 = 0

b) Y = C+I+G

5000 = 3250 + 1000 - 50r + 1000

50r = 250

r = 5%

c) IF the Value of "G = 1500"

Private savings = Y-T-C = 5000 - 1000 - 3250 = 750

National savings = Y-C-G = 5000-3250 - 1500 = 250

Public savings = T-G = 1000-1500 = -500

d) IF the Value of "G = 1500"

Y = C+I+G

5000 = 3250 + 1000 - 50r + 1500

50r = 750

r = 15%

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