Question

2) Consider the following model of an economy. Note we introduce the external sector as a source of savings. Y = F(R,N) C = C(Y-TA I = I(r) NX = NX(Y-TA) Y = C +I+G+NX Wherer is the real rate of interest, and investment is a declining function of the real interest rate such that when real interest rates rise, investment falls. Note also that consumption is a positive function of disposable income such that as disposable income rises, so does consumption. On the other hand, as income rises so does imports and therefore NX is inversely related to disposable income. There are no transfers in this economy. a) Consider only the domestic sector for now. Suppose that the government decides to spend more but is compelled by law to follow a balanced budget. What can you say about the impact of this disturbance on total savings, S, the interest rate, r, and the level of investment, 1. Present your results in a well-labelled diagram. b) Now fold in the external sector. Can you tell if your outcome is any different from part (a)? Explain! c) Now suppose that government spending rises while cutting taxes at the same time. Again, considering only the domestic sources of savings for now what can you say about the effects of this policy on S, the interest rate, r, and the level of investment, 1. Compare your answer to part (a). How does the diagram from part (a) change if at all from this case. d) Now fold in the external sector. Can you tell if your outcome is any different from part (c)? Explain!

Answer 1

(a) In a domestic sector, suppose the Govt. will decide to spend more but is compelled by law to follow a balanced budget then the total savings (S) will increase from S₀ to S₁ and there is no impact on the interest rate (r) and the level of investment (I). In this way the aggregate demand curve and optimum "Y" will increase simultaneously. Here the net export is not considered. This situation is depicted in the following figure.

کاک , 1ره = AS Id(Y-TA) + I (8) + G. 7 e(Y-TA) + I(%) +60 16) t-ers, Y-C=5468 Y-C=s, T h e eli-TA) - - -

(b) If the economy fold in the external sector then we can include net export (NX) in aggregate demand. In part (a), we consider the domestic sector so that there is no intervention of net export (NX). Now we are consider NX. So that is why the aggregate demand curve is shifts to upward direction and in this way the total savings (S) is increases and there is no impact on rate of interest (r) and the level of investment (I). This situation is explain by the following figure.

X=AS CI,G,S, NX (Y-TAI (2) + G + NXY-TA) 7 7 1 1 o e-TA) + It ity -CS Y-C=So I (7) •CLT-TA TO Y

Here, as a result the optimum "Y" increases from Y₀ to Y₁ and the total savings rises from S₀ to S₁

(c) In domestic sector when the Govt. spending rises while cutting taxes at the same time then the (C+I+G) curve or aggregate demand curve will shifts upward due to increase in govt. expenditure and the (S+T) curve will shifts left due to cutting the taxes. Here the segment of savings will increase and no impact on interest rate and the level of investment. For this change the equilibrium point will shifts to leftward and the optimum "Y" will decreases fro Y₀ to Y₁ . This situation depicted in the following diagram.

e+s+T C+S+To -ct ITG CI, S,T, G, et It Go 7 (STT) (St To) elsius C ik-TA)

(d) Now fold in the external sector. We include net export (NX) here. Here the outcome is same as part (c). This can be shown in following figure.

Ct St To e+S+T CI, GST, NX € - C+I+G+NA -et It Go +NX -Go -I(M) ·C(Y-TA) AAT Y, TO YO