(35 marks) Consider an economy described by the following equations: Y = C + I +
ID: 1191965 • Letter: #
Question
(35 marks) Consider an economy described by the following equations:
Y = C + I + G
Y = 11000
G = 4000
T = 2000
C = 300 + 0.7(Y T)
I = 700 70r
(a) (5 marks) Find the equilibrium real interest rate r using the goods market clearing condition.
(b) (5 marks) Find private savings, public savings and national savings.
(c) (5 marks) Now find the equilibrium real interest rate r using the loanable funds market clearing condition.
(d) (5 marks) Show the loanable funds equilibrium on a plot with r on the vertical axis and S, I on the horizontal axis. (e) (5 marks) Suppose G increases to 4200. Find the new equilibrium real interest rate r.
(f) (5 marks) On your plot, show how this increase in G affects the loanable funds market equilibrium.
(g) (5 marks) What variable got “crowded out” when G increased?
Explanation / Answer
(a). IS ; Y = C + I + G.
Y = 300 + 0.7 (Y - T ) + 700 - 70r + 4000. Solving we get,
11000 = 300 + 0.7 Y - 0.7 T + 700 - 70r + 4000.
11000 = 300 + 0.7 (11000) - 0.7(2000) - 70r + 4000.
11000 = 11300 - 70r
70r = 300
r = 4.285.
(b). Private savings = Y - T - C.
We first calculate C.
C = 300 + 0.7 ( Y-T)
C = 300 + 0.7 ( 11000-2000).
C = 6600. Substituting the values.
private savings = 11000 - 2000 - 6600
private savings = $2400.
Public savings = T-G
Public savings = 2000-4000
Public savings = -2000.
National savings = Y - C -G [ point to note here is that the national savings is equal to investment ].
National savings = 11000- 6600 - 4000
National savings = $400.
Cross-check I = 700-70r
700- 70*4.285
$400.
(c). The demand for loanable funds is the INVESTMENT and the supply of loanable funds is the SAVINGS.
Savings = private savings+ public savings
savings = (Y-T-C) + (T-G)
savings = Y-C-G = 400
Loanable funds market clearing condition => I=S.
700-70r = 400
r = 4.285.
(d). when plotting graphically with r on vertical axis and S,I on horizontal axis, the supply on loanable funds (savings) would be a vertical curve parallel to y-axis. And the demand for loanable funds (investment) would be a downward sloping curve from left to right. The intersection of demand and supply curve determines the real rate of interest 'r'.
When G increases to $4200, after substituting all values in equation C+I+G, Y = 300+7700-1400+700-70r+4200.
11000 = 11500 - 70r
70r = 500
r = 7.142.
(f). As the government expenditure increases to $4200, this implies that the demand for loanable funds increases and the downward sloping demand curve would shift to right. With a vertical supply curve, the real rate of interest would go up as is the case. With G=4000, r =4.285 and G=4200, r =7.142.
(g). When G increased, as we saw that the real rate of interest increases because of which private investment crowds out as now it would be more expensive for firms to carry out loans as cost of borrowing has increased.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.