Question

5. Show the relationship between private saving, public saving, investment, and the current account. 6. If the U.S. dollars give a 3% rate of return, and euro gives 4%. Suppose the current exchange rate 1 euro=1.2 dollars. And expected exchange rate 1.2 euro=1 dollar. Should you invest in U.S. dollars or euro?

Answer 1

Answer 5)

Investment equals to Private savings plus Public savings

Private savings = Y-T-C

Public savings = T-G

I=Y-T-C+T-G

Investment=Y-C-G

Current Account is difference between savings and Investment

Current Account=Savings-Investment=Y-T-C+T-G-I=Y-C-G-I

Hence above equation gives relationship between Private savings, Public Savings , Investment and Current account

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Ans 6)

If we borrow 1 EUR at 4% rate and exchanged with USD for 1 EUR=1.2 USD then we have 1.2 USD

1.2 USD can be reinvested with 3% to get 1.2(1.03)=USD 1.236 at the end of year 1

At year 1 we have,

1.2 euro= 1 usd

therefore we get,

1.2*1.236 Euro=1.236 USD

1.4832 Euro=1.236 USD

We can payback 1.04 EUR from 1.4832 EUR hence we earn risk less profit equals to EUR 0.0432

We should invest in Euro to earn this profit.