Question

5. Macroland’s domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by

the following equations:

S = 1500 + 2000r I = 2000 – 4000r KI = -100 + 6000r

a) Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment, and the real interest rate.

b) Repeat part (a), assuming that desired national saving declines by 120 at each value of the interest rate (in other words, the National Saving curve in the loanable funds market shifts to the left, in a parallel fashion, by 120 units). What effect does this reduction in domestic saving have on capital inflows in Macroland?

Answer 1

S = 1500 + 2000r

I = 2000 – 4000r

KI = -100 + 6000r

a) At equilibrium, the equation is set to S+KI = I and solve r.

1500 + 2000r-100 + 6000r = 2000 – 4000r

12000r= 600, r = 0.05 or 5%

substitute in the 3 equations,

S = 1500 + 2000*0.05 = 1600

I = 2000 – 4000*0.05 = 1800

KI = -100 + 6000*0.05 = 200

b) New national saving = (1500-120) + 2000r = 1380+2000r

setting the equilibrium and solving r

S+KI = I

1380+2000r-100 + 6000r = 2000 – 4000r

12000r = 720, r= 0.06

substitute in the 3 equations,

S = 1380+ 2000*0.06 = 1500

I = 2000 – 4000*0.06 = 1760

KI = -100 + 6000*0.06 = 260

capital inflows increased with decrease in domestic savings.