Question

Suppose you are given the following information about a closed economy:

Y=$40,000
T=$6,000
Spr =$1,000+0.15∗(Y−T)+1,000∗r
I=$5,600−2,000∗r
G=$6,800
Real GDP = Income
Net tax collections
Total investment function
Government purchases
d) (5 points) Without any calculations, what are the implications of changes in the amount of government deficit/surplus for the equilibrium interest rate in the economy? Note that in this model, a reduction in investment in the economy does not change long run GDP. Here the level of GDP was given exogenously; that is, the model cannot explain changes in GDP. However, our simple model here makes predictions about changes in the composition of GDP. e) (5 points) Suppose that the government increases its purchases without increasing its tax collection. What prediction does this model make about changes in the shares of consumption, investment, and government purchases in GDP? f) (5 points) Calculate the equilibrium real interest rate in this economy. Also, if you are told that the rate of inflation in this economy is 2.5%, what is the nominal rate of interest? g) (5 points) What are the total levels of saving and investment at this rate of interest? How much of the total saving is comprised of government saving and how much is private saving?

Answer 1

Increases in government budget deficits lead to higher interest rates, which can crowd out private investment. The share of consumption, investment, and government purchases within GDP adjusts accordingly. Calculating the equilibrium real interest rate and accounting for inflation provides the nominal rate, while total savings and investment are the sum of private and government saving.

Step-by-step explanation:

When a government increases its budget deficit by borrowing more, the demand curve for financial capital shifts. This shift reflects an increased demand for funds, causing equilibrium interest rates to rise in financial markets. Using the model where government purchases increase without a rise in tax collections, the shares of consumption, investment, and government purchases in GDP would change as follows: investment would likely decrease due to higher interest rates, consumption would potentially decrease or stay the same, and government purchases would increase. This shift could lead to crowding out of private investment.

To calculate the equilibrium real interest rate, we equate savings to investment. Given the inflation rate of 2.5%, the nominal interest rate would be calculated using the Fisher equation, which adds the real interest rate to the inflation rate. Finally, for total levels of saving and investment, we would need to calculate private and government saving separately to understand their contributions to total saving.