Question

3. Why Doesn't Capital Flow to Developing Countries? The Canadian Econ- omy is described by the following information on output, consumption, fiscal policy and investment: Y = 5,000 C = 250 +0.75(Y – T) T = 1,000 G = 2,000 I(r) = 1,000 – 50r Canada is a small open economy. a) If the world interest rate is equal to 5, what are net exports? Is Canada lending or borrowing from the rest of the world? b) The country of Sri Lanka has a lower capital stock than Canada. It has output, Y' = 2,500, government spending equal to 1,000 and taxes equal to 500. The consumption function is the same as Canada, however, the investment function is: I'(r) = 2,000 – 50r What are net exports for Sri Lanka in this case? c) Compare investment in Canada and Sri Lanka. Which country has a higher level of investment? Why do you think this is? Hint: Think about what determines the demand for capital. d) The Case Study on page 145 of your text suggests that in reality capital does not flow to countries like Sri Lanka, but instead to countries like Canada. One reason for this might be a risk premium, so that the real interest rate paid by Sri Lanka is: r=p* +0 Where p* is the world interest rate of 5 percent and is the risk premium. If you observe that NX' = 0 for Sri Lanka, what must the risk premium be?

Answer 1

Y=sooo c=250 to 5 CA-T) T = 1,000 G = 2000 I Cr) = 1000-sor Y- C+I+G2 Part A Y=250 to.5 CY-1000) + 2000 + 1000-sor soou a zso tois (9000) +2000+ 1000 -50r = 250 2000 2000 t 1000 - Sor 0 = 250 -sor 250 = re -forsvinne 5 ani The rate of interest of Canada is 5 leo scannedinith CamScanner

1ooo -sor 1000 - SOXS = 70 = 2sot 00. 56 4000) 250 2000 = 2250 0 Calculating NX for Canada YECEI + GEN X O Sooo = 22sot zsot 2000 + NX NX=0 Het exports is o in canada ca Scanned with To CamScanner

As the interest rate in Canada - and rest of the world is some so the net borrowing and lending will be zero bas at the same interest rate lending is equal to borrowing part B For sri lanka case - Y- 2.5oo - ae looo ( 250+CO:s ly- - T = soo - I- 2000 -sor o xn Y = ct I ta 2500=2so a to.r(2,500 - Soo) CS Scanned with to looo + zool-sor CamScanner

2500 = 2 sot 1000 t 1000 +2000 – Sor 250o = 2450 G250 -sor - 1250 = -sor -ro 3.5 oris is in sri lanka There capitataflow it Investment = 2000 - sor = 2000 – SOX325 W I = 250 = 250 gram .. Y = C+Ita ENX 250o = c + 2sot 1000 + NX - c = 250+ 0.5 (2000) - 250t looo = 1250 25oo = 12so +2so +1000 NX - Nx= 0 2_Seened with CamScanner

Part C o Investment in Canada I'Cr) = tooo -sor a leoo - Sox 5 E = 1000 - 2 SO 76 250 Investment in sri lanka ANI=22000 - sort I to y 2ooo - Sox3S 2000 - 1250 a t = 250 Inustments in Canada is so and investment in Sri lanka is 250 The investment in Sri lanka is low because in. Sri Lanka the interest rate which determines Investment is high. [ Note: There is an Inverse relation blu Investment and interest rate] CamScanner

Partd In reality the capital does not flow to the Srilanka even if it has higher interest rate it flows to Canada The reason for this is that sri-lanka is more prone to instat economic instablity which can lead to fluctuation in interest rate. Thus to attracte Capital Flowo sri-lanka have a nither reat interest rate r= r * to r is the Di fate rate do r * on d Sri lanka interest = World interst Q = is risk premium UUU tn +92 Risk 35= s t Q Q = 30 154 AM premium is so in sri-lanka Ics Scanned with CamScamer

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