Question

Please show graphs too. I believe I have the right answer but not sure.

1. 1. (10 pts) An open economy is defined by the identity: Y C +1 + G + NX, where Y-real GDP )NX Net exports (real exchange rates), C-C(Y-T), T lump sum taxation and G-exogenously determined governmental expenditures. Assume arn economy's loanable funds market is initially at equilibrium, r and $. After a recent survey, it is determined that consumers are pessimistic about their economic well-being and plan to reduce their level of consumption. What will be the net effect of this change in consumption on real interest rates and real foreign exchange rates? (Use the loanable funds market).

Answer 1

Lonable fund theory is also called as the neo-classical theory of interest. The main proponent of this theory was Prof. Robertson.

Lonable fund theory is termed better than the classical theory of interest because where classical theory only considered savings only a part taken out of current income, the Lonable fund theory also takes into account bank loans, dishoarded and disinvested wealth. Thus it is also called as the monetary theory of interest.

Now as the question assumes that due to pessimism, the consumers plan to reduce their level of consumption.

We know that income has two parts: savings and consumption. Thus Y=C+S

Other things being equal, there is an inverse relationship between savings and consumption. Therefore when people start consuming less, they would tend to save that money. L

Now, savings being a part of Supply side of Lonable funds, will increase the overall supply of lonable funds. This can be seen from the diagram below :

DD is the demand of lonable funds and S1S1 is the supply. Since the savings has increased due to lower consumption, the overall supply of lonable funds has increased from S1S1 to S2S2. Earlier the equilibrium was at E1, with interest rate R1 and L1 quantity of funds. Due to an increase un supply, the equilibrium has moved down to point E2. At this point the Rate of interest is R2 and quantity of funds is L2. Thus we see that on one hand the rate of interest has decreased amd on the other hand the quantity of lonable funds has increased.

IMPACT ON FOREIGN EXCHANGE RATE

We know that the demand of home currency very much depends upon the rate of interest our country offers. A higher rate of interest lures more people to invest, whereas a lower interest rate compels people to take their money out. This can be shown from the following diagram.

2 2 vanti dollaus

Due to reduced interest rate in home country, as we have seen earlier, the demand for dollars has decreased. As a result the demand curve D1D1 shifts to left to D2D2. Therefore the exchange rate moves down from E1 to E2 and the quantity also decreases from Q1 to Q2.

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