3. [40 Points] Assume that potential GDP (n, supply, is 5,000. The is as follows

Question

3. [40 Points] Assume that potential GDP (n, supply, is 5,000. The is as follows: By definition, Y . C+1 + G. Consumption 0.3(Y-). Investment in percent. Taxes (T) are 1,000 and government s (C) is given by the equation C's 1,000 + ment (n is given by the equation t= 1,500-50r, where r is the real interest rate pending (6) is 1,500. a. What is the equilibrium value of r? Wh b. at are the values of private saving, public saving, and national saving? Assume that r is currently equal to 2%. The economy is currently not in equilibrium. Describe the nature of the disequilibrium in both the market for goods and services and the loanable funds market. Describe how the economy will quickly converge to equilibrium. Now assume there is a technological innovation that makes businesses want to invest more. possible interest rate, investment demand is higher (investment demand shifts to the right). What is the new equilibrium value of ? What are the new values of private saving, public saving, and national saving? What is the impact of the increase in investment demand on investment spending? Why is this the case? c. d. It raises the investment equation to l = 2,000-50r. In other words, for every e. f.

Explanation / Answer

a) Y= C+I+G      OR   Y-C-G (Savings) = I (Investment)

=> 5000 = 1000+0.3(5000 - 1000) + 1500 - 50r + 1500

=> 5000 = 2200+1500-50r+1500

=> r = 4%

b) Public savings = Taxes - Government spending = 1000 - 1500 = -500

This means government is running budget deficit.

Private savings = Y - T - C = 5000 - 1000 - (1000 + 0.3(5000 - 1000)) = 1800

National savings = Public savings + private savings = -500 + 1800 = 1300

d) Y = C+I+G

=> 5000 = 1000 + 0.3(5000 - 1000) + 2000 - 50r + 1500

=> 5000 = 2200 + 2000 - 50r + 1500

=> 5000 = 3700 + 2000 - 50r => r = 14%

e) Answer will be same as (b).

f) Increase in investment demand will lead to increase in interest rates which in turn will result in decrease investment spending as increase in interest rates will cause increase in cost of borrowing.

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