Problem Set-3 Dr Arshad Ali Bhatti

ECN-316 Office C-026, IIIE

Spring, 2017

To be handed in on May 10, 2017

Q-1: Assume that an economy is characterized by the following equations:

Y= C + I + G
Y(GDP) = 6000
C = 600 + 0.6 (Y – T)
I = 2000 – 100r
T = 500
G = 500,

where r is the real rate of interest in percent, T is tax and G is a government

spending.

a. What are the equilibrium values of C, I, and r ?

b. What are the values of private saving, public saving, and national saving?
If government spending rises to 1000, what are the new equilibrium?
c. values of C, I, r, private saving, public saving, and national saving?
Q-2: Suppose the government decides to reduce spending and (lump-sum) income taxes
by the same amount. Use the long-run classical model of the economy to
graphically illustrate the impact of the equal reductions in spending and taxes. State
in words what happens to the real interest rate, national saving, investment,
consumption, and output.
Q-3: Consider a small open economy described by the following equations:
Y = C + I + G + NX,
Y = 5,000,
G = 1000, T = 1000,
C = 250 + 0.75(Y – T)
I = 1000 - 50r,
NX = 500 - 500 ε ,
r = r* = 5,
where ε is the real exchange rate and r* is the world interest rate.
a. In this economy, solve for national saving, investment, the trade balance, and the
equilibrium exchange rate.
b. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade
balance, and the equilibrium exchange rate. Explain what you find.
c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again
1000). Solve for national saving, investment, the trade balance, and the equilibrium
exchange rate. Explain what you find.