Explain why government budget deficits crowd

Subject: Economics / Microeconomics
Question 1: Explain why government budget deficits crowd out private investment spending in a
economy, but crowd out net exports in a small open economy. Assume prices are flexible and
that factors of production are fully employed in both economies. Use the basic version of the
open-economy model where net exports is function of real exchange rate. Use diagrams to
explain your answer.

Question 2: The real interest rates and real exchanges rates are constant and equal in North Country
and South Country. The Fisher equation and purchasing power parity hold in both countries. If the
nominal interest rate is 8 percent in North Country and 10 percent in South Country, do you
expect North Country’s nominal exchange rate to appreciate, depreciate, or remain the same?

Question 3: In classical macroeconomic theory, the concept of monetary neutrality means that changes
in the money supply do not influence real variables. Explain why changes in money growth
affect the nominal interest rate, but not the real interest rate. Use quantity theory of money and
fisher equation to answer this question.

Question 4: Consider a money demand function that takes the form (M/P)^d = Y/3i, where M is the
quantity of money, P is the price level, Y is real output, and i is the nominal interest rate
(measured in percentage points).
a) What is the velocity of money if the nominal interest rate is constant?
b) How will the level of the velocity of money change if there is a permanent (one time)
increase in the nominal interest rate, holding other factors constant?

Question 5: Assume that an employer believes that the “efficiency” (e) it can get from a particular
worker, as a function of the hourly wage (w), is given by function
e = –0.125w + 0.15w^2 –0.005w^3, at least up to a wage of 30.
a) Create a table of w, e, e/w, and w/e for wages equal to 5, 10, 14, 15, 16, 20, and 25.
b) Which wage gives the highest ratio of efficiency per unit of labour cost?
c) Once the firm has hit on an optimal w, whatever it is, would cutting wages whenever
demand falls off increase or decrease wages per unit of efficiency?

Question 6: Assume that we have an economy where a certain share (f) of the unemployed (U) manage
to find work during a given period of time! Assume also that a certain share (s) of the employed
are separated from their jobs every period! Denote employment by E and the total labor force by
a) Derive an expression for the unemployment rate (U/L) in a steady state! What is
unemployment if s = 0.02 and f = 0.5?
b) Repeat the exercise for f = 0.25!

Question 7: Consider the following Neoclassical model of the economy, where the domestic interest
rate # and the world interest rate #? are in percentage terms. Show all your work.
Y = 1000, C = 50 + 0.7(Y ? T), NX= 100 ? 100E, I = 200 ? 10r, ? = 5%, G = 200, T = 100
(a) Find the equilibrium real interest rate, national saving, and investment in a closed economy.
Show the equilibrium real interest rate on a saving-investment diagram with # measured on the
vertical axis.
(b) Now assume the small economy opens up to trade. Calculate the real exchange rate (#), trade
balance and net capital outflow. Show the trade balance on a saving-investment diagram with #
measured on the vertical axis
(c) Assume that contractionary fiscal policymakers enacted by reducing government spending to
100. Find the new real exchange rate, trade balance and net capital outflows. Redraw the diagram
from part (b) to show the changes.

Question 8: A hypothetical economy can be described by the Solow growth model. Answer the below
questions for this economy by using the following information:
= ?k
saving rate (s) = 0.20
depreciation rate (d) = 0.12
initial capital per worker (k) = 4
population growth rate (n) = 0.02
a. What is the steady-state level of capital per worker?
b. What is the steady-state level of output per worker?
c. What is the level of steady-state consumption per worker?
d. What is the steady-state level of investment per worker?


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