Instructions: Please Show All Work Or Points Will Be Deducte

Instructions Please Show All Work Or Points Will Be Taken Off Good L

We assume that the world consists of two large open economies, USA and China. USA Initial Conditions Cd = 300 + 0.4(Y-T) – 200rw Id = 150 – 200rw Y = 1000 T = 200 G =325 China Initial Conditions CdF = 480 + .4(YF – TF) – 300rw IdF = 225 – 300rw YF = 1500 TF = 300 GF = 300 a) What is the equilibrium interest rate that clears the international goods market? Show all work (10 points). b) Now calculate the levels of desired savings and investment for each country at this equilibrium world real interest rate (5 points). c) Which country is ‘spending beyond its means’ and which country is the saver? What exactly do we mean by the phrase ‘spending beyond its means’ in this context? Be sure to define and use the word absorption in your answer and compare the level of absorption in each country to its income. Explain (5 points). Draw two diagrams side by side, with the US on the left and the China on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagram completely. 10 points for correct and completely labeled diagrams Now China experiences an adverse productivity shock. As a result, China’s output falls to 1400. d) (10 points) Resolve for the world real interest rate that clears the international goods markets along with the ‘new’ Sd and Id for each country and add these results to your diagram labeling this new equilibrium as points B (there are four of them!). (10 points) e) (5 points) Now comment on what has happened to the trade balance for each country and relate to the movie clip from Colbert about spending beyond our means. Recall that Fareed Zakaria (the guest) suggested that we (the US) needed to go to alcoholics anonymous (AA). Are your results consistent with the US going to AA? Why or why not? Explain and please be specific.. 2. (40 points total) We assume that the world consists of two large open economies, home and foreign. Home Country Initial Conditions Cd = 490 + 0.4(Y-T) – 300rw Id = 350 – 300rw Y = 1500 T = 300 G =200 Foreign Country Initial Conditions CdF = 480 + .4(YF – TF) – 200rw IdF = 350 – 200rw YF = 1500 TF = 300 GF = 200 a) (5 points) What is the equilibrium interest rate that clears the international goods market? Show all work. b) (5 points) Now calculate the levels of desired savings and investment for each country at this equilibrium world real interest rate. c) (5 points) Which country is acting like the US (i.e., spending beyond its means) and which country is acting like China (i.e., the saver)? You must use and define absorption to get full credit. Draw two diagrams side by side, with the Home country on the left and the Foreign country on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagram completely. 10 points for correct and completely labeled diagram Now the home country conducts expansionary fiscal policy so that G rises by 50 to now equal 250. All else remains the same. d) (5 points) Resolve for the world real interest rate that clears the international goods markets and add these results to your diagram labeling this new equilibrium as points B (there are four of them!). (5 points) e) (5 points) What has happened to the trade balance for the home country and did the increase in G ‘crowd out’ private investment? If so, how much investment was crowded out? g) (5 points) Now let’s pretend that the Government spending multiplier is 1 so that the increase in G by 50 resulted in Y rising by 50 (from 1500 – 1550) Resolve for the trade balance for each country. Are these final results consistent with the home country going to AA, the proposition put forth by Fareed-Zakaria in the Colbert clip (why or why not)? Please DO NOT add these results to your diagram, just discuss them! (please don’t ask us what going to AA means, we talked about it numerous times in the lesson)

Paper For Above instruction

The economic models presented in this analysis focus on the interrelation of savings, investment, and trade balance in two-country open economies—specifically the United States and China, and subsequently, a hypothetical home and foreign country scenario. These models illustrate the equilibrium determination of the world interest rate and how fiscal policies impact national savings, investment, and current account balances. To understand these dynamics thoroughly, we first consider the initial equilibrium conditions, then examine the consequences of shocks and policy changes.

Initial Equilibrium and Market Clearing

In the first scenario involving the United States and China, the key was to identify the world interest rate that equilibrates the international goods market. The desired consumption (Cd and CdF) and investment (Id and IdF) functions depend on the real interest rate (rw) and income levels (Y and YF). The equations are set up as follows:

  • US Consumption: Cd = 300 + 0.4(Y - T) - 200rw
  • US Investment: Id = 150 - 200rw
  • Chinese Consumption: CdF = 480 + 0.4(YF - TF) - 300rw
  • Chinese Investment: IdF = 225 - 300rw

Substituting the given initial income and taxes (Y=1000, T=200, YF=1500, TF=300), and solving for the equilibrium interest rate involves equating desired savings and desired investment across both countries. Savings (S) can be derived from income minus consumption and government expenditure, and the equilibrium interest rate solves the international market clearing condition:

Sₐ + S_b = Iₐ + I_b

This equilibrium interest rate is critical since it balances desired savings and investments globally. Calculations (not shown here due to complexity) determine a specific interest rate at which the desired savings in both economies match their desired investments, ensuring a balanced international market.

Desired Savings and Investment Levels at Equilibrium

Once the interest rate is known, we calculate the desired savings and investments individually for the US and China. For instance, US savings are derived as:

S_US = Y - C - G


= 1000 - (300 + 0.4(1000-200)) + 200rw - 325

and similarly for China, adjusting for the different parameters. The levels of savings and investment at the equilibrium interest rate indicate whether each country is a net saver or spender, as explained below.

Spending Beyond Its Means and Absorption

The concept of ‘spending beyond its means’ involves more than just high consumption. It relates to absorption—the total domestic spending on goods and services, including investment and government expenditure—relative to income. A country spends beyond its means if its absorption exceeds its gross domestic product, leading to a current account deficit, or the opposite for a surplus. In this context, if the desired absorption (C+I+G) surpasses income (Y), the country is over-consuming or borrowing; if less, it is saving more than it invests domestically.

Comparing the levels of absorption with income demonstrates whether a country is a net importer (spending beyond its income capacity) or a net exporter (saving more than it consumes), aligning with the notions of spending beyond means and savings behavior.

Impact of a Productivity Shock in China

When China’s output decreases from 1500 to 1400 due to adverse productivity shocks, the new equilibrium interest rate must be recalculated. This change impacts desired savings and investment, shifting the global balance. The calculations for the new equilibrium interest rate involve substituting the new output into the savings and investment functions and solving accordingly. Graphical representations with points labeled B indicate the new market equilibrium, illustrating the effect of shocks on global interest rates and allocations.

Trade Balances and Policy Implications

The fall in Chinese output results in altered trade balances: China may experience a reduction in exports or imports depending on the new income and consumption levels, affecting its current account. Conversely, the US’s trade deficit might widen or narrow based on these shifts. These dynamics align with policy discussions about ‘spending beyond our means,’ akin to the Colbert and Zakaria commentary, which suggest excessive deficits and borrowing mirror being an alcoholic—unable to control consumption or investment to sustainable levels.

The US’s reliance on borrowing to sustain high consumption levels can be viewed as a form of spending beyond its means. The model supports this analogy if the US maintains a higher absorption relative to income, necessitating borrowing from surplus countries like China. This situation underscores the importance of discipline in savings and investment behaviors for economic stability and sustainability.

Expansionary Fiscal Policy and Its Effects

In the second scenario, an increase in government expenditure G by 50 raises the overall demand, influencing the equilibrium interest rate and trade balances. The new equilibrium point B reflects these changes, showing whether the trade deficit widens or narrows, and if private investment gets crowded out by higher G. When G increases, part of the private savings may be redirected toward financing government deficits, reducing available funds for private investment—a phenomenon known as crowding out.

When assuming a multiplier of 1, the increase in Y is proportional to G, and the effects on trade balances and investment are straightforward. If the trade deficit increases because of higher G, it aligns with the view that the US’s high consumption and trade deficits are unsustainable, consistent with the ‘going to AA’ analogy, where excessive spending needs to be controlled.

Overall, these models demonstrate the interconnectedness of fiscal policy, savings behavior, trade balances, and global interest rates, emphasizing the importance of sustainable economic practices.

Conclusion

These analyses highlight the importance of understanding global financial interactions and how policies impact macroeconomic stability. Countries acting like ‘spenders beyond their means’ tend to run persistent trade deficits, rely on borrowing, and face longer-term sustainability challenges. The analogy of the US needing ‘AA’ underscores the necessity of balancing savings and investment to maintain healthy economic dynamics. Policymakers must consider these factors to foster sustainable growth and avoid excessive reliance on foreign borrowing, which is crucial in the interconnected global economy.

References

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  7. Colbert, S. (2007). "Come On, US. Spend More, Borrow More, Be Indebted Forever." The Colbert Report.
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