Chapter 3
1 a Find the equilibrium level of GDP in an economy in which investment is always 200 and the
consumption function is described by the following algebraic equation:
C = 120 + 0.6Y
Note that this is a two-sector economy.
Equilibrium level of income is given by
Y
A
1 c
A=I+a
= 200 + 120 = 320
Ye 
A
1 c
Ye 
320
1  0 .6
= 800
b Do the same for an economy in which investment is fixed at 150 and the
consumption function is:
C = 250 + 0.75Y
Y
A
1 c
A=I+a
= 150 + 250 = 400
Ye 
A
1 c
Ye 
400
1  0.75
= 1600
c In each of the cases above, how much saving is there in equilibrium?
S=Y–C
S = Y – a – cY
S = –a + (1 – c)Y
S = –a + sY
S = –120 + (0.4*800)
S = 200
or at equilibrium I = S so I & S = 200 (2-sector model only)
In the second case:
S=Y–C
S = Y – a – cY
S = –a + (1 – c)Y
S = –a + sY
S = –250 + ( 0.25*1600)
S = 150
or at equilibrium I = S so I & S = 150 (2-sector model only)
2 Take an open economy with a constant price level and a fixed exchange rate characterised by an
mpc of 0.85, a tax rate of 40%, and a marginal propensity to import of 0.26. Autonomous
expenditure is initially as follows:
Autonomous consumption
Government expenditure
Investment
Exports
300
3 600
1 000
2 600
a Calculate the equilibrium level of national income, the government budget deficit or surplus,
and the deficit or surplus on the current account of the balance of payments.
x = c(1 – t) – m = 0.85(0.6) – 0.26
= 0.25
A
Ye 
1 x
a I G X
Ye 
1  0.25
Ye 
7500
 10,000
0.75
Government balance:
G = 3600
T = tY = 0.4 x 10 000 = 4000
therefore T – G = 400 (surplus)
Balance of Payments:
X = 2600
M = mY = 0.26 x 10 000 = 2600
M – X = 0 (balanced)
b Calculate the effect on equilibrium national income, the government’s budget deficit or
surplus, and the current account of the balance of payments, of
(i) a rise in exports of 300 and
(ii) a rise in government expenditure of 450
(i) a rise in exports of 300 (comment on the results)
X = 300; Y = = 400
Y = 10 400
T = 4160 G = 3600
T – G = 560 surplus
Since Y has increased, taxes have also increased, but G has remained unchanged.
Thus the Government balance improves.
X – M = 2900 – 0.26(10 400) = 196 surplus
The increase in exports has improved the balance of trade, but the rise in income has
also increased the level of imports, so the trade surplus increases by less than the
increase in exports.
(ii) a rise in government expenditure of 450 (comment on the results)
A
x = 600
1 x
Y = 10 600
T = 4240
T – G = 190 surplus
With G increasing, the budget surplus falls, despite the increased income generating
higher tax revenue.
Y 
X – M = 2600 – 0.26(10 600) = 156 deficit.
Since X is unchanged, but higher income results in higher imports, the
balance of trade deteriorates and a trade deficit emerges.
3
Why is the paradox of thrift a paradox?
Paradox of thrift: If one person saves more he or she will be better off in the
future, but if everyone tries to save more (with no increase in investment),
national incomes may fall and total saving does not actually increase. It is
easiest to illustrate this for a two-sector model where Y = Yd
Note: s increases, rotating S to the left, but I remains fixed. The paradox is that the
attempt to save more does not result in more saving. People just end up saving a
higher proportion of a smaller income. Indeed the act of saving makes everyone worse
off because incomes are lower. The assumption that I remains fixed is crucial in this
analysis. A drop in Y may actually diminish confidence and I may even fall.
4
What is National Saving and how can the Saving-Investment gap diagram (Figure 3.9)
be derived from the equations for Output and Income in the four-sector circular flow
model? Use this diagram to illustrate the situation in Japan (see Box 3.10)
National Savings: the sum of public and private saving = (T – G) + S
Output = C + I + G + X – M
Income Y = C + T + S
(I – S) + (G – T) = (M – X) (see text pages 93-94)
I = S + (T – G) + (M – X)
National Investment I = IPUBLIC + IPRIVATE
= National Saving + (X – M)
National Saving = (T – G) + S
The ‘gap’ must be filled by borrowing foreigners' saving. Size of the gap = (X –
M). More correctly, using the GNI concept, the gap = the Current Account
Deficit CAD = X – M + net international investment income.
In the case of Japan
Private
Public Ipu
savingpublic
Foreign
investment
X-M
dissaving
Private Ipt
5
Find out from the daily newspaper and from any other sources what is being said about
saving and investment in New Zealand. What are the issues and what are the proposals
that are being discussed?
It is likely that students will find concerns about the size of the Current Account
Deficit and the quality of investment that foreign saving is financing. There may also
be misguided discussions about how New Zealanders should save more to increase
national saving. Students must remember that national saving is the sum of private
and public saving and private includes business saving also.
Possible commentary students are likely to find include:
 Concerns about the gap between national saving and investment.
 Concerns about low household saving.
 Use of the tax system to encourage saving – should we have incentives for saving
for retirement?
 Over-investment in housing.
 Under-investment in the new technology and new industries.
 Concern about regional investment.
 Saving and investing for the needs of an ageing population.
Students can look up the Herald’s website: http://www.nzherald.co.nz