For each of the following scenarios, use a well-labeled diagram of the supply and demand for saving and investment to analyze the effects on the real interest rate, equilibrium national savings,...

  1. For each of the following scenarios, use a well-labeled diagram of the supply and demand for saving and investment to analyze the effects on the real interest rate, equilibrium national savings, and equilibrium investment.

a)    U.S. military involvement abroad declines. As a result, the government deficit shrinks

b)    A new generation of computer-controlled machines becomes available. These machines produce manufactured goods much more quickly with fewer defects.

c)    Concerns about job security cause people to engage in more precautionary savings.

d)    Businesses become pessimistic about consumer demand for their products in the future. As a result, they expect that the prices at which they will be able to sell their products at will decline.

  1. A firm is considering an investment in a machine that will enable the firm to earn $500 in after-tax revenue next year. The firm’s next best alternative is to save the money at a 10% annual interest rate [assume that there are no taxes on the interest from savings.

a)    If the machine costs $450 today, should the firm make the investment in the machine or not? Briefly explain why or why not. [KEY: Assume that the purchase and borrowing costs ALL must be incurred in this one upcoming year

b)    Now suppose that before the firm makes the decision, the prevailing interest rate on savings accounts increases to 12%, but there is no change in the expected revenue from the investment. Does the machine remain a worthwhile investment? [Again, assume that all relevant costs must be incurred in this one year]

5.    You are given the following information about the open economy of Macroland for 2014:

- GDP                               $100 billion

- Consumption                           $70 billion

- Tax revenues                           $15 billion

- Transfer payments          $8 billion

- Government spending              $20 billion

- Exports                                    $10 billion

- Imports                                    $12 billion

  1. What is the level of investment spending in Macroland in 2014?
  2. What is the level of capital inflow for Macroland in 2014? Is Macroland borrowing from foreigners or lending to foreigners? Explain your answer.
  3. What is private savings equal to in Macroland in 2014?
  4. What is the government budget balance equal to in Macroland in 2014?
  5. Does national savings + capital inflow equal investment spending for this economy in 2014? Explain your answer.
  6. Is the government of Macroland saving or borrowing funds in 2014? Explain your answer.
  1. Macroland’s domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations:

S = 1500 + 2000r

I = 2000 – 4000r

KI = -100 + 6000r

a)    Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment, and the real interest rate.

b)    Repeat part (a), assuming that desired national saving declines by 120 at each value of the interest rate (in other words, the National Saving curve in the loanable funds market shifts to the left, in a parallel fashion, by 120 units). What effect does this reduction in domestic saving have on capital inflows in Macroland?

  1. Suppose that First National Bank has $100 million in checking deposits, $20 million in reserves, and $80 million in loans. Suppose that the reserve requirement is 10% of deposits.

a)    Compute First National’s excess reserves (i.e., the amount of reserves in excess of required reserves). Explain why First National might choose to hold additional reserves above the required amount.

b)    Suppose that there is a $10 million withdrawal of deposits. If First National wants to minimize the amount of loans it calls in, how much will its reserves and loans change in response to the reduction in deposits?

c)    Suppose that instead of a $10 million outflow of deposits there is a $20 million outflow of deposits. If First National wants to minimize the amount of loans it calls in, how much will its reserves and loans change in response to the reduction in deposits?

Principles of Macroeconomics.

1 Answer

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

We cannot answer this many questions at once on this site.  I will give you as many answers as I can fit in the space provided.

1A (Deficit decreases).  This will cause national savings and equilibrium investment to rise.  Essentially, there will be more money available to be invested, which means that the rate of investment and saving will move right along the investment function.  This will reduce the real interest rate.   (Please refer to this link to see labelled, interactive graphs that depict this process.)

1B (Better technology). 

2A) If the company is going to pay $450 for the machine and it could have made $45 by investing that money (10% of $450), it should buy the machine.  This is because the company will get $500 if it invests the money and only $495 (the $450 it didn’t spend plus the $45 in interest) if it does not invest.  This means that it will make more money if it buys the machine.

2B)  Here, you use the same logic as in 2A.  However, the firm can now make 12% interest, which changes the numbers.  12% of $450 is $54.  That means that the firm would “make” $504 if it does not invest while it would only make $500 by investing.  Therefore, the firm should not buy the machine if the interest rate is at 12%.

#5 (The GDP question)

In order to understand this question, you need to understand that GDP can be expressed by the equation GDP = Consumption + Investment + Government purchases + Net Exports (where net exports = exports – imports).  In question 1, then, we see that 100 (GDP) = 70 (consumption) + Investment + 20 (Government spending) – 2 (because net exports are negative.  That gives us 100 = 88 + I which means that I is 12.  In this case, the level of investment is $12 billion. 

We do not use the taxation and transfer payments in that question because they are not relevant.  They are, however, relevant in questions 4 and 6.  We see that the government is only taking in $15 billion in tax revenues.  Meanwhile, it is spending $20 billion in purchases and $8 billion in transfer payments.  This means the government is actually disbursing $28 billion while taking in $15 billion.  This means the government budget balance is $-13 billion.  We would say there is a $13 billion deficit.  The government would therefore have to borrow money.

Bank question

There are two kinds of reserves—required reserves and excess reserves.  The government sets the level of required reserves and anything that is kept over that percentage is excess.  In this case, the bank has $100 billion in deposits and it is required to hold 10% in reserves.  This means that the required reserves are $10 billion.  If the bank has $20 billion in total reserves, $10 billion of that is made up of excess reserves.  The bank might want to hold these excess reserves because it might be worried about the economy in the near future.  It might fear that the economy will slump and companies or individuals to whom it loans money might not be able to repay their loans.  Therefore, it would make fewer loans than it legally could.