Question

2. Consider two neighboring countries that are currently completely isolated from each other. Also, Country B’s households are much more sophisticated compared to those in Country A and they have a consumption function that depends on the (real) interest rate in addition to disposable income:

Country A:
Y = 12000
C = 2000 + 0.9(Y-T) I = 1500 – 100r
G = 1500
T=2000

Country B:
Y=8000
C = 1000 + 0.8(Y-T) – 400r I = 1000 – 200r
G = 1000
T=1000

a. Calculate the equilibrium real interest rate and the resulting level of investment spending in Country A, using the equilibrium in the goods market condition. Remember, Country A’s economy is completely unrelated to Country B.

b. Please calculate private savings, public savings and the equilibrium interest rate in Country B. Then, using the equilibrium real interest rate, please calculate the amount of consumption and investment expenditure in Country B. Remember, Country B’s economy is completely unrelated to Country A. Needless to say, you need to use the equilibrium in the financial markets condition.

c. Now suppose that these two countries decide to combine their financial markets (but strangely, imports/exports among these countries and the movement of physical capital/labor between the two are still strictly banned). Now citizens and governments of both countries are free to lend in both countries. Meanwhile, firms of these countries are able to borrow from lenders in either country (and completely ignore foreign currency considerations). As a result, there will now be one equilibrium real interest rate that will apply in both countries. Please calculate the equilibrium interest rate in this “combined multi-country financial market” using the equilibrium in the financial markets condition.

d. What is the macroeconomic outcome of the liberalization and integration of the two countries financial markets? Are consumers in Country B consuming more or less? Which country’s firms (those in A or B) benefit the most from this policy? Please briefly explain why.

Answer 1

Country A

Y = 12000

C = 2000 + 0.9(Y-T)

I = 1500-100r

G = 1500

T = 2000

Equllibrium price for country

Y = C+I+G

12000 = 2000 + 0.9(Y-T) + 1500-100r + G

12000 = 2000 + 0.9(12000-2000) + 1500 - 100r+1500

100r = 2000

r =20%

C = 2000 + 0.9(Y-T)

C = 2000 + 0.9(12000-2000) = 11000

I = 1500 - 100r

I = 1500-100x20 = -500

Country B

Y = 8000

C = 1000 + 0.8(Y-T) - 400r

I = 1000-200r

G = 1000

T = 1000

Equllibrium price for country

Y = C+I+G

8000 = 1000 + 0.8(Y-T) - 400r + 1000-200r + G

8000 = 1000 + 0.8(8000-1000) - 400r + 1000-200r + 1000

600r = 600

r =1%

C = 1000 + 0.8(Y-T) - 400r

C = 1000 + 0.8(8000-1000) - 400x1 = 6200

I = 1000 - 200r

I = 1000-200x1 = 800

a) Country A r = 20%

Country B r = 1%

b) Country B

Private savings = Y - T -C = 8000-1000-6200 = 800

Public savings = T-G = 1000-1000= 0

National savings = 800+0 = 800