Question

Suppose that the relevant parameters of the economy are t=0.33, Ir= 900, Cy=0.75, r=10 , x=0.6. An irrational exuberance causes a stock market boom which leads the consumer spending to increase by $20 billion at a constant level of disposable income. WhY would be the increase in interest rates in response to this- driven consumption boom?

Answer 1

An increase in consumption spending of $20 billion a year equals a withdrawal of savings for $20 billion a year from the flow-of-funds. A 1%-point rise in the interest rate decreases the investment by $9 billion. A 1-percent-point rise in the interest rate also results to a 10 point reduction in the real exchange rate ?. A 10 point fall in the real exchange rate ?, in turn, decreases net exports by $6 billion. Thus in equilibrium the interest rate should increase by 2.2% to ensure that in the flow of funds market the supply equal to demand. Also it will ensure that the reduction in investment leads to an equal fall in savings from abroad (produced by the change in exports) and the fall in private saving (produced by the boom in consumption).