PROBLEM SET 4
Chapter 20, pp. 508-509: 1*, 2, 3*, 5*, 6
Chapter 22, pp. 569-570: 2, 10
Suppose that the U.S. has a marginal propensity to consume (MPC or c1) of .8. Its
marginal propensity to import (MPM or m1) is .1. Suppose that government spending
increases by $1 billion.
1.
a.
b.
c.
d.
In what direction and by how much does U.S. equilibrium national
income (Y) change, assuming that the U.S. is a small open economy?
In what direction and by how much will U.S. imports change?
If the U.S. is a large economy (i.e. the U.S. economy influences the
economies of other countries), what effect will the increase in U.S. government
spending have on foreign national incomes? Will foreign national incomes
increase or decrease? (Numerical answer not possible). Why?
Will the change in foreign national incomes (from part c) tend to
counteract or reinforce the change in U.S. national income (from part a)?
Explain.
Suppose that the U.S. has a marginal propensity to consume (MPC or c1)) of .85. Its
marginal propensity to import (MPM or m1) is .4. Suppose that domestic investment
spending decreases by $2 billion.
2.
a.
b.
c.
d.
3.
In what direction and by how much does U.S. equilibrium national income
(Y) change, assuming that the U.S. is a small open economy?
In what direction and by how much will U.S. imports change?
If the U.S. is a large economy (i.e. the U.S. economy influences the
economies of other countries), what effect will the decrease in U.S. investment
spending have on foreign national incomes? Will foreign national incomes
increase or decrease? Why?
Will the change in foreign national incomes (from part c) tend to
counteract or reinforce the change in U.S. national income (from part a)?
Explain.
Suppose that we have the following information about the U.S. economy.
 U.S. national income is initially 2000.
 The U.S. trade balance is initially –10 (deficit of 10), with exports of 10 and
imports of 20.
 The U.S. MPC (c1) is .5.
 The U.S. MPM (m1) is .1.
For each separate part below, find the new equilibrium levels of national income,
imports, and the trade balance. In both cases, start with the initial situation above.
a.
b.
U.S. investment spending decreases by 20.
U.S. exports increase by 5.
2
4.
a.
Beginning from a position of equilibrium in the diagram below and
a zero trade balance, what is the effect of a decrease in government
spending on:
i.
The equilibrium level of national income?
ii.
The trade balance in goods and services?
AD
AD
A
45o
Y1
Y
XGS, MGS
MGS
X1=M1
A
XGS
0
Y1
b.
c.
d.
Y
Answer part (a) for a decrease in the interest rate.
Answer part (a) for a decrease in exports.
Answer part (a) for an increase in foreign national income.
3
SELECTED ANSWERS
(Be careful! I put this problem set together really quickly. If you think
anything is wrong, let me know.)
TEXTBOOK, p. 508 #2: An adjustable peg means that the government only changes
the par value when there is a “fundamental” or permanent disequilibrium. The par
value presumably will not change very often. A crawling peg means that the
government changes the par value often according to a set of macroeconomic
indicators.
TEXTBOOK, p. 508 #6:
epnuts per $1
S$
3.5 pnuts per $1
3.0 pnuts per $1
PAR Value
D$
QS$
a.
b.
c.
QD$
#$
Since there is private excess demand for dollars at par, the Pugelovian
government could sell the desired dollars out of its official reserve
asset holdings.
Since QS$ (see graph) are being earned by Pugelovian exporters at par,
the government could require that they turn in those dollars to the
government and the government could decide who will get to use
those dollars.
The government could increase domestic interest rates. This raises
the rate of return on domestic (Pugelovian) assets relative to foreign
assets. International investors will want to buy more Pugelovian assets
and will sell more dollars on the foreign exchange market. This increases
the supply of dollars, shifting the supply curve (in graph above) to the
right. At the same time, the demand for dollars will decrease since $assets will be less attractive. This shifts the demand curve to the left.
Both of these will bring the market exchange rate closer to par value.
TEXTBOOK, p. 569 #2: Disagree. The recession in the U.S. reduces U.S. national
income, so U.S. residents reduce spending on all kinds of things, including spending on
imports. The decrease in U.S. imports is a decrease in the exports of other countries,
4
including those of Europe. The reduction in European exports reduces production and
incomes in Europe so the growth of real GDP in Europe declines.
TEXTBOOK, p. 570 #10:
a.
Our country’s imports increase, due to the marginal propensity to import;
exports stay the same.
b.
Our country’s exports decrease; Imports also decrease because lower
exports will lower our incomes.
c.
The real exchange rate ((Pf x e)/P) decreases when P increases. This
means that foreign products become relatively cheap (or our products
become relatively expensive). Thus, our exports decrease and our
imports increase.
d.
The real exchange rate ((Pf x e)/P) increases when Pf increases more than
P.
This means that foreign products become relatively expensive (or our
products become relatively cheap). Thus, our exports increase and our
imports decrease.
ANSWERS TO ADDITIONAL PROBLEMS
1.
a.
Multiplier is 1/(1-.8+.1) = 3.3  Output/income increases by $3.3 billion.
b.
Imports increase by .1 x $3.3 billion = $0.33 billion
c.
Foreign national incomes will increase because an increase in US imports
increases foreign exports.
d.
The increase in foreign incomes will reinforce the increase in U.S. incomes
because foreigners will buy more U.S. products, increasing U.S. exports and thus
increasing U.S. incomes more than the initial increase in U.S. government spending.
2.
a.
Multiplier is 1/(1-.85+.4) = 1.82  Output/income decreases by $3.64
billion ($2 billion x 1.82).
b.
Imports decrease by .4 x $3.64 billion = $1.46 billion
c.
Foreign national incomes will decrease because a decrease in US imports
decreases foreign exports.
d.
The decrease in foreign incomes will reinforce the decrease in U.S.
incomes because foreigners will buy fewer U.S. products, decreasing U.S. exports and
thus decreasing U.S. incomes more than the initial decrease in U.S. investment
spending.
3.
NOTE: The multiplier = 1/(1-.5+.1) = 1.67
a.
Y (2000 – (20 x 1.67)) = 1966.6; M (20 – 3.34) = 16.67; Trade
Balance (10 – 16.67) = -6.66.
b.
Y (2000 + (5 x 1.67)) = 2008.35; M (20 +.835) = 20.835; Trade
Balance (10 – 20.835) = -10.835.
5
4.
a.
AD
AD
A
45o
Y1
Y
XGS, MGS
MGS
X1=M1
A
XGS
Surplus
Y
6
b.
A decrease in the interest rate increases investment spending.
AD
AD
A
45o
Y1
Y
XGS, MGS
MGS
Deficit
X1=M1
A
XGS
Y
7
c.
A decrease in exports decreases AD.
AD
AD
A
45o
Y1
Y
XGS, MGS
MGS
X1=M1
A
XGS
Deficit
d.
An increase in foreign national income will increase the exports of the
nation in question. This increases the nation’s aggregate demand and equilibrium
income. The increase in exports will produce a trade surplus. Graphically, everything is
the opposite of the graph in part c.