1)- Suppose you are asked to advise a risk-avert individual who is to invest $50 million for one year either in the U.S. or in U.K. Given the following information, where would you advise her/him to i

Consider the following model:

1. Y = C + I + G + X – M

2. C = 300 + 0.5Y

3. I = 200

4. G = 200

5. X = 200

6. M = 150 + 0.25 Y

Please answer the following questions:

1. How much is equilibrium income or output (Y)?

2. What is the equation for the saving function in this economy?

3. What are the values of MPC, MPS and MPM?

4. What is the value of spending multiplier for this economy?

5. At equilibrium income is the trade balance in deficit or surplus? By how much?

6. In an effort to reduce the trade deficit government decides to cut its spending by 100. What will be the impact on the trade balance?

7. Another way to improve the position of trade balance is to encourage exports. Suppose government provides subsidies to exporters that result in an increase in exports by 100. What will happen to the trade balance and by how much?

1. 1. How much is equilibrium income or output (Y)?

Following the notes, we must substitute equations 2-6 into 1. We have

Y = C + I + G + X – M

After substitution, we will have

Y = 300 + 0.5 Y + 200 + 200 + 200 – 150 – 0.25 Y

Or 0.75 Y = 750 which implies the equilibrium income, Ye = 1000

It is important to make sure that the answer is correct. To check this answer, all we need is to find out how much is each components of aggregate demand at equilibrium income of 1000 and then whether (1) is satisfied.

C = 300 + 0.5 (1000) = 800

I = 200

G = 200

X = 200

M = 150 + 0.25 (1000) = 400

Now substitute these values in (1), we have

1000 = 800 + 200 + 200 + 200 – 400

As can be seen, the equality holds meaning that the answer is correct.

1. 1. What is the equation for the saving function in this economy?

The consumption function is C = 300 + 0.5 Y.

Saving is the difference between income and consumption. Thus, we have

S = Y – C or

S = Y -300 – 0.5Y = -300 + 0.5 Y . Therefore, the saving function is:

S = -300 + 0.50 Y

1. 1. What are the values of MPC, MPS and MPM?

MPC is the slope of consumption function. Thus, MPC = 0.5

MPS = 1- MPC = 1-0.5 = 0.5 or the slope of saving function.

MPM is the slope of import function which is 0.25

1. 1. What is the value of spending multiplier for this economy?

1. 1. At equilibrium income is the trade balance in deficit or surplus? By how much?

We need to find how much are exports and imports at equilibrium income.

X = 200

M = 150+ 0.25 Y = 150 + 0.25 (1000) = 400

Thus, X – M = 200 – 400 = -200 Trade balance is in deficit by 200.

1. 1. In an effort to reduce the trade deficit government decides to cut its spending by 100. What will be the impact on the trade balance?

To assess the impact of this policy on the trade balance, we must find out what does this policy do to exports and what does it do to imports.

It has no effect on exports because exports are fixed at 200. Thus,

∆ X = 0.

What does it to imports?

As G changes, it has multiplier effect on income or Y. At high level of income we import more. By how much?

∆M = 0.25 ∆Y

however, ∆Y = 4/3 ∆G = (4/3)(-100) = (-400/3)

Thus, ∆M = 0.25 (-400/3) = -33.3

Therefore, with no change in exports, trade balance will improve by 33.3.

1. 1. Another way to improve the position of trade balance is to encourage exports. Suppose government provides subsidies to exporters that result in an increase in exports by 100. What will happen to the trade balance and by how much?

This time,

∆ X = 100.

And since increase in exports has the same multiplier effect on Y, income will increase by (4/3)(100) which will lead to an increase in imports by (4/3)(100)(0.25) = 33.3 Thus, ∆M = 33.3

Therefore the net change in the trade balance will be an increase of 66.7 because

∆ TB = ∆X - ∆M = 100 – 33.3 = 66.7