Question

Consider an open economy. Let e denote the real exchange rate and Y denote income. Suppose e = 1.5. Let consumption be given by C = 500 + 0.8Yd, exports be given by EX = 200 + 0.9e, and imports be given by IM = 150 + 0.2Yd - 0.5e. Finally, let domestic investment, government purchases and taxes be, respectively, I = 300, G = 200 and T = 120.

1. What is the import balance?

2. What is the current account balance?

Answer 1

Y = C + I + G (1)

and Yd = Y - T

Now, subtract T from both sides of equation (1), we get:

Y - T = C + I + G - T

Yd = C + I + G -T

Now, put the values of C, I , G and T , we get:

Yd = 500 + 0.8 Yd + 300 + 200 - 120

Yd - 0.8 Yd = 880

0.2 Yd= 880

Yd = $ 4400 (disposable income).

Imports (IM) = 150 + 0.2 Yd - 0.5 e

By putting the value of Yd= 4400 and e= 1.5 , we get:

IM = 150 + 0.2(4400) - 0.5(1.5)

= 150 + 880 - 0.75

IM = $ 1029.25 (Import balance).

Exports (EX) = 200 + 0.9e

= 200 + 0.9(1.5)

EX = 200 + 1.35

EX = $ 201.35 (Export balance).

Current account balance = Exports - imports

= $( 201.35 - 1029.25)

= $ - 827.9 (Current account deficit).