example

1. example • Consider a closed economy with • Y=20000 • G=T=0 • C=1000+0.8*(Y-T) • I=5000-500 r ----------------------------------------------------------- • What is the level of interest rate? ----------------------------------------------------------- Now, assume this is a small open economy and the global interest rate is 5% • Would this country be a net borrower or lender? • What would the level of net exports be? • Now, assume that the level of government spending increases to 3000, would this country be a net borrower or lender? And what would the level of NX be? • Now assume that G is reduced to 0, but T is reduced to -1000, what would be the level of NX? • Now assume that G=T=0, but the investment function changes to: I=8000-500r

2. Part 1 – closed economy Y = C + I + G 20000 = 1000 + 0.8 * (20000) + 5000 – 500 * r • r = 4 ----------------------------------------------------- OPEN ECONOMY 1. If the world interest rate exceeds the interest rate of the closed economy, then this economy will be a net lender, and hence experience trade surplus. • Y = C + I + G + NX 20K = 1K + 0.8 * (20K) + 5K – 500 * 5 + NX  NX = 500 • NS decline by 3K, since Public sector saving is now -3K. Note, because T remain unchanged, there is no impact on the private sector saving. 20K = 1K + 0.8*(20K) + 5K - 500*5 + 3K + NX  NX = -2500 The country has become a net borrower. • now, G= 0 but T = -1K. Note, that now both, public and private saving are affected. 20K = 1K + 0.8*( 20K – (-1K)) + 5K – 500 * 5 + NX  NX = - 300 • G=T=0 BUT I = 8000 – 500 r 20K = 1K + 0.8*(20K) + 8K – 500 * 5 + NX  NX = -2500 note that in this case the investment needs of this economy increased and as a result it turned into a net borrower internationally.