Consider the following classical economy. y40+10v L 280-2(WP) G=T=20 L\'--80+2(

Question

Consider the following classical economy. y40+10v L 280-2(WP) G=T=20 L'--80+2( WP) a) Calculate the equilibrium values of interest rate, saving, investment and consumption. b) Suppose that the private investment rises to I 98-100r Find the values of the change in saving, investment and consumption. (c) Suppose that the govermment spending increases to 56 from 20 without ncreasing taxes If the increase in the government spending is financed by selling bonds, what is the change in saving, investment and consumption?

Explanation / Answer

(a) Since G = T, public saving is zero and therefore, S = I.

- 10 + 80r = 80 - 100r

180r = 90

r = 0.5

S = - 10 + (80 x 0.5) = - 10 + 40 = 30

I = 80 - (100 x 0.5) = 80 - 50 = 30

In labor market equilibrium, LD = LS

280 - 2(W/P) = - 80 + 2(W/P)

4(W/P) = 360

W/P = 90

L = 280 - (2 x 90) = 280 - 180 = 100

y = 40 + 10 x (100)0.5 = 40 + 10 x 10 = 40 + 100 = 140

Consumption = Y - S = 140 - 30 = 110

(b) As before, since G = T, public saving is zero and therefore, S = I.

- 10 + 80r = 98 - 100r

180r = 108

r = 0.6

S = - 10 + (80 x 0.6) = - 10 + 48 = 38

I = 98 - (100 x 0.6) = 98 - 60 = 38

Consumption = y - S = 140 - 38 = 102

(c) Since G > T, Public saving (Sp) = T - G = 20 - 56 = - 36, therefore

S = S + Sp = - 10 + 80r - 36 = - 46 + 80r

Equating with I,

- 46 + 80r = 80 - 100r

180r = 126

r = 0.7

S = - 46 + (80 x 0.7) = - 46 + 56 = 10 (Saving will fall by (30 - 10) = 20)

I = 80 - (100 x 0.7) = 80 - 70 = 10 (Investment will fall by (30 - 10) = 20)

Consumption = 140 - 10 = 130 (Consumption will rise by (130 - 110) = 20)

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