Question

Consider an economy described by the equations: ? =??! "?! "

2
?=2500+0.5(?−?) ?=2000−60? ?=2000 ?=1300 where A = 4, K = 1000 and L = 4000. a) (8 points) Find the supply of loanable funds in this economy.

b) (8 points) Government can affect the equilibrium real interest rate by changing the government spending. What should be the new government spending, ?#$%, such that new equilibrium real interest rate is 10?

Answer 1

2(a) Supply of loanable funds in the economy (y)=$8000

Calculations------

Given that---- Y= A√K√L

Where A= 4, K= 1000,L=4000

Y= 4×√1000×√4000=$8000

2(b) New govt Spending ( Gnew)= $1100

Calculations------

AD= C+I+G

Where C=2500+0•5(Y-t), I= 2000-60r,G= 1300

We know,at Equilibrium demand for loanable funds = Supply of loanable funds ( AD=AS or Y)

2500+0•5(8000-2000)+2000-60r+1300=8000

r= 40/3=13•3%

It is Equilibrium rate of interest

Now, if govt needs to maintain r=10%, the new govt Spending--------

2500+0•5(8000-2000)+2000-60(10)+G=8000

G= $1100