ECON110 Tutorial 12

```ECON110
Tutorial 12
Chapter 17
Problem No. 1 and 4
Problem 1
• Current Account
The current account records all transaction of goods
and services or a direct transfer of income.
Conventions:
• Transactions that bring in foreign exchange are
recorded as credits.
• Transactions that lead to an outflow of foreign
exchange are recorded as debits.
• Capital Account
The capital account records all transactions that
involve the acquisition of either an asset or a
liability.
Convention:
• New liabilities  credit items (Why?)
• Acquisition of assets  debit items (Why?)
• The current and capital account balances sum
to zero.
• CAB + KAB = 0
a.
• An Australian exporter sells software to Israel.
stock in an Israeli company.
– Software sale to Israel  Current account credit
– Stock purchase  Capital account debit
b.
• An East Timorese firm uses proceeds from its
sale of oil to Australia to buy Australian
government bonds.
• In Australian BoP:
– Oil purchase  CA debit (CA deficit)
– Bonds purchase (by East Timorese firm)  KA Credit (KA
surplus)
– CAB + KAB = 0
c.
• An East Timorese firm uses proceeds from its
sale of oil to Australia to buy oil-drilling
equipment from an Australian firm.
– Oil purchase  current account debit (deficit)
– Bond purchase  current account credit (surplus)
– CAB + KAB = 0
Problem 4.
• A country’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.
Equilibrium: S + KI = I
1500+ 2000r – 100 + 6000r = 2000 – 4000r
2000r + 6000r + 4000r = 2000 – 1500 + 100
12000r = 600
r = 600/12000 = 0.05
Then
S = 1500 + 200r = 1500 + 2000(0.05) = 1600
I = 2000 – 4000r = 2000 – 4000(0.05) = 1800
KI = -100 + 6000r = -100 + 6000(0.05) = 200
b.
• Repeat Part a), assuming that desired national
saving declines by 120 at each value of real
interest rate. What effect does a reduction in
domestic saving have on capital inflows?
Now S = (1500 – 120) + 2000r = 1380 + 2000r
Equilibrium: S + KI = I
1380 + 2000r -100 + 6000r = 2000 - 4000r
r = 0.06
S = 1500
KI = 260
I = 1760
c.
• Concern about the economy’s macroeconomic
policies causes capital inflows to fall sharply so
that now KI = -700 + 6000r. Repeat Part (a). What
does a reduction in capital inflows do to domestic
investment and the real interest rate?
r = 0.10
S = 1700
KI = -100
I = 1600
Reduction in capital inflows
Domestic investment decreases
Real interest rate increases
Capital inflows augment the domestic saving pool, increasing the funds
available for investment, while capital outflows reducing the amount of
saving available for investment.
Last Test
• A tax cut
–
–
–
–
Disposable income (Y-T) increases
Consumption C = C0 + c(Y-T) increases
Aggregate demand increases: AD shifts right, the economy moves to A.
At A, actual output higher than potential output: Y1 > Y*, expansionary
gap.
– If the CB does nothing, inflation increases: SRAS shifts up to SRAS’
– In the long run, inflation increases to a higher level and output returns
to potential level, the economy is at C.
– If the CB doesn’t want the inflation rate to increase, the CB could shifts
up its policy reaction function (PRF) while the economy is at B. Higher
the economy returns to the initial equilibrium at A.
Inflation
C
π’
π
B
A
Yn
Y’
Output
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