Problem Set 12: The Effects of Government Borrowing Open Economy, Savings Responds to the Interest Rate

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1 Eco Intemediate Macoeconomics John Lovett oblem Set 12: The Effects of Govenment Boowing Open Economy, Savings Responds to the Inteest Rate Oveview: In this poblem set, you will investigate how changes in govenment spending, financed by changing the govenment s suplus o deficit, affect an economy. In paticula, you will investigate five scenaios diffeing by the amount of govenment spending (and boowing) in an economy. You will detemine the equilibium conditions fo an economy at full employment. This mateial is coveed in you chaptes 9 (especially pp ) and 12 (especially pp ) text and notes. Assumptions: It is assumed that the economy is at full employment. Futhe, impots (M) ae assumed to be constant. 1 Savings esponds to the inteest ate. Finally, govenment boowing is assumed to have nothing to do with the inteest ates. i,e, You S Gov and D Gov columns should be the same numbe all the way down fo a given situation. Example: On page two you ae given a completed example showing the equilibium conditions an economy. U.S. supply and demand fo loanable funds is composed of pivate U.S. demand fo loanable funds (i.e. Investment), the pivate U.S. supply of loanable funds (i.e. boowing by households), and govenment boowing (a demand fo loanable funds). Note, if the govenment is unning a suplus, it is supplying loanable funds. To this we need to add foeign (i.e. est of wold) supply and demand. utting it all togethe. We find that the loanable funds maket will be in equilibium at a eal inteest ate of 5.5%. At that inteest ate, U.S. quantity supplied is $400 less than U.S. quantity demanded. The diffeence is made up by $400 of capital inflows fom aboad. Likewise, quantity supplied fom the est of the wold is $400 geate than quantity demanded. This means (the same) $400 of capital inflows fom aboad. U.S. investment has to be $1,400. Since U.S. impots ae $900, and thee ae $400 of capital flows coming into the U.S., one can deduce that U.S. expots ae $500. You Tun: Now comes the fun pat. On pages 3 5, you ae given 3 diffeent situations. The situations only diffe by the amount of govenment spending. In situation 1, the govenment is unning a balanced budget. In situation 2, it is unning a suplus. In situation 3, it is unning a suplus. Fill in the numbes, simila to the example, & answe the questions on page 6. Tun in page 6. 1 In actuality, impots would espond to changes in 1) the foeign exchange ate caused by govenment boowing. This will not, howeve, ovetun the esults found in this poblem set. In fact, it would stengthen the esults. Ex. U.S. Govt. Boowing value of the U.S. $ M, i.e. a widening tade deficit. Impots would also change in esponse to savings (which is a function of the inteest ate). The moe households save, the less they spend on both consumption of domestic goods and on foeign impots. This would mean that govenment boowing has less of an effect on the tade deficit.

2 ivate U.S. Maket U.S. Govt Boow/Lend U.S. ivate + Govt. Rest of Wold Mkt S iv D iv = I S Gov D Gov S USA D USA S ROW D ROW S D 7.5% $1,900 $1, % $0 $ % $1,900 $1, % $2,400 $ % $4,300 $2, % $1,800 $1, % $0 $ % $1,800 $1, % $2,200 $ % $4,000 $2, % $1,700 $1, % $0 $ % $1,700 $1, % $2,000 $1, % $3,700 $2, % $1,600 $1, % $0 $ % $1,600 $1, % $1,800 $1, % $3,400 $2,900 $1,400 + $1,400 $500 $1,250 = 5.5% $1,500 $1, % $0 $ % $1,500 $1, % $1,600 $1, % $3,100 $3, % $1,400 $1, % $0 $ % $1,400 $2, % $1,400 $1, % $2,800 $3, % $1,300 $1, % $0 $ % $1,300 $2, % $1,200 $1, % $2,500 $3, % $1,200 $1, % $0 $ % $1,200 $2, % $1,000 $1, % $2,200 $3,700 $400 $1,500 $500 $750 $900 + = Example You ae given the following ivate U.S. Maket, Rest of Wold Maket Govt Spending (excl. tansfes) = $1,250 Taxes (net of tansfes) = $750 Impots = $900 (this does not change) You deive the following Govt. Deficit o Suplus = $500 E = 5.5% Investment = $ 1,400 Savings = $ 1,500 Expots = $500 Net Capital Flows = $400 fom ROW to US Tade Deficit o Suplus = $400 Resouce Mkt 2

3 ivate U.S. Maket U.S. Govt. Boow/Lend U.S. ivate + Govt. Rest of Wold Mkt. S iv D iv = I S Gov D Gov S USA D USA S ROW D ROW S D 7.5% $2,500 $1, % 7.5% 7.5% $2,400 $ % 7.0% $2,400 $1, % 7.0% 7.0% $2,200 $ % 6.5% $2,300 $2, % 6.5% 6.5% $2,000 $1, % 6.0% $2,200 $2, % 6.0% 6.0% $1,800 $1, % 5.5% $2,100 $2, % 5.5% 5.5% $1,600 $1, % 5.0% $2,000 $2, % 5.0% 5.0% $1,400 $ % 4.5% $1,900 $2, % 4.5% 4.5% $1,200 $1, % 4.0% $1,800 $3, % 4.0% 4.0% $1,000 $1, % Situation 1 You ae given the following (none of which changes) ivate U.S. Maket, Rest of Wold Maket Govt Spending (excl. tansfes) = $4,000 Taxes (net of tansfes) = $4,000 Impots = $2,000 (This does not change) You deive the following Govt. Deficit o Suplus = E = Investment = Savings = Net Capital Flows = Expots = Tade Deficit o Suplus = Resouce Mkt 3

4 ivate U.S. Maket U.S. Govt. Boow/Lend U.S. ivate + Govt. Rest of Wold Mkt. S iv D iv = I S Gov D Gov S USA D USA S ROW D ROW S D 7.5% $2,500 $1, % 7.5% 7.5% $2,400 $ % 7.0% $2,400 $1, % 7.0% 7.0% $2,200 $ % 6.5% $2,300 $2, % 6.5% 6.5% $2,000 $1, % 6.0% $2,200 $2, % 6.0% 6.0% $1,800 $1, % 5.5% $2,100 $2, % 5.5% 5.5% $1,600 $1, % 5.0% $2,000 $2, % 5.0% 5.0% $1,400 $ % 4.5% $1,900 $2, % 4.5% 4.5% $1,200 $1, % 4.0% $1,800 $3, % 4.0% 4.0% $1,000 $1, % Situation 2 You ae given the following (none of which changes) ivate U.S. Maket, Rest of Wold Maket Govt Spending (excl. tansfes) = $5,200 Taxes (net of tansfes) = $4,000 Impots = $2,000 (This does not change) You deive the following Govt. Deficit o Suplus = E = Investment = Savings = Net Capital Flows = Expots = Tade Deficit o Suplus = Resouce Mkt 4

5 ivate U.S. Maket U.S. Govt. Boow/Lend U.S. ivate + Govt. Rest of Wold Mkt. S iv D iv = I S Gov D Gov S USA D USA S ROW D ROW S D 7.5% $2,500 $1, % 7.5% 7.5% $2,400 $ % 7.0% $2,400 $1, % 7.0% 7.0% $2,200 $ % 6.5% $2,300 $2, % 6.5% 6.5% $2,000 $1, % 6.0% $2,200 $2, % 6.0% 6.0% $1,800 $1, % 5.5% $2,100 $2, % 5.5% 5.5% $1,600 $1, % 5.0% $2,000 $2, % 5.0% 5.0% $1,400 $ % 4.5% $1,900 $2, % 4.5% 4.5% $1,200 $1, % 4.0% $1,800 $3, % 4.0% 4.0% $1,000 $1, % Situation 3 You ae given the following (none of which changes) ivate U.S. Maket, Rest of Wold Maket Govt Spending (excl. tansfes) = $3,400 Taxes (net of tansfes) = $4,000 Impots = $2,000 You deive the following Govt. Deficit o Suplus = E = Investment = Savings = Net Capital Flows = Expots = Tade Deficit o Suplus = Resouce Mkt 5

6 . Hee s My oblem Set # 12. Name: at 1: Situation 1 at 2: Situation 2 at 3: Situation 3 at 4: Geneal uestions 1. What condition is the govenment budget in?: a. deficit b. balanced c. suplus 2. What is the equilibium eal inteest ate? 3. What is the $ value of U.S. Investment? 7. What condition is the govenment budget in?: a. deficit b. balanced c. suplus 8. What is the equilibium eal inteest ate? 9. What is the $ value of U.S. Investment? 13. What condition is the govenment budget in?: a. deficit b. balanced c. suplus 14. What is the equilibium eal inteest ate? 15. What is the $ value of U.S. Investment? 19. In this poblem set, we assumed that the economy is at F. i.e. We assumed that changes in govenment spending do not change the size of poduction. What time peiod ae we assuming? a. the shot-un b. the long-un c. the doo un-un-un _ 4. What is the $ value of intenational capital flows? 10. What is the $ value of intenational capital flows? 16. What is the $ value of intenational capital flows? 20. When thee was an incease in govenment spending, financed by a deficit, what if anything was cowded out? 5. Which diection ae these flows going? a. fom the U.S. to ROW b. fom the ROW to U.S. 11. Which diection ae these flows going? a. fom the U.S. to ROW b. fom the ROW to U.S. 17. Which diection ae these flows going? a. fom the U.S. to ROW b. fom the ROW to U.S. 6. What is the value of U.S. expots? 12. What is the value of U.S. expots? 18. What is the value of U.S. expots? 21. Neatness Counts! 6