me de 3. (40 Points] Assume that potential GDP (n, supply, is 5,000. The demand

Question

me de 3. (40 Points] Assume that potential GDP (n, supply, is 5,000. The demand side of the economy is as follows: By definition, Y-C + 1 + G. Consumption (C) is given by the equation C-1.000 + 0.3(Y T) Investment () is given by the equation -1,500-50r, where r is the real interest rate in percent. Taxes (T) are 1,000 and government spending (G) is 1,500. a. What is the equilibrium value of r? b. What are the values of private saving, public saving, and national saving? C. Assume that r is currently equal to 2%. The economy is currently not in equilibrium. Describe the nature of the disequilibrium in both the market for goods and services and the loanable funds market. Describe how the economy will quickly converge to equilibrium d. Now assume there is a technological innovation that makes businesses want to invest t raises the investment equation to /-2,000-50r. In other words, for every more. I possible interest rate, investment demand is higher (investment demand shifts to the right). What is the new equilibrium value of r? What are the new values of private saving, public saving, and national saving? What is the impact of the increase in investment demand on investment spending? Why is this the case? e. f.

Explanation / Answer

(a) In equilibrium, Potential GDP = Y = C + I + G

Y = 1,000 + 0.3(Y - 1,000) + 1,500 - 50r + 1,500

Y = 4,000 + 0.3Y - 300 - 50r

0.7Y = 3,700 - 50r

0.7 x 5,000 = 3,700 - 50r

3,500 = 3,700 - 50r

50r = 200

r = 4%

(b) C = 1,000 + 0.3 x (5,000 - 1,000) = 1,000 + 0.3 x 4,000 = 1,000 + 1,200 = 2,200

Private saving (Sp) = Y - C = 5,000 - 2,200 = 2,800

Public saving (Sg) = T - G = 1,000 - 1,500 = -500

National saving = Sp + Sg = 2,800 - 500 = 2,300

(c) When r = 2%, it is less than equilibrium value of r. Therefore at lower interest rate, investment will be higher than savings, therefore to ensure equilibrium, interest rate will start rising, corresponding to which, investment will start falling and saving will start rising until they are equal at equilibrium interest rate of 4%. In loanable funds market, lower interest rate will increase the quantity of loanable funds demanded and decrease the quantity of loanable funds supplied, causing a shortage. As a result interest rate will start rising until they are equal at interest rate of 4%. It is assumed that potential GDP remains unchanged at 5,000 during this adjustment process.

(d) When I = 2,000 - 50r,

Y = 1,000 + 0.3(Y - 1,000) + 2,000 - 50r + 1,500

Y = 4,500 + 0.3Y - 300 - 50r

0.7Y = 4,200 - 50r

0.7 x 5,000 = 4,200 - 50r

3,500 = 4,200 - 50r

50r = 700

r = 14%

NOTE: As per Answering Policy, 1st 4 parts have been answered.

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