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Chapter 25: Problem 2

Given the following information about the open economy of Regalia, what is the level of investment spending and private savings, and what are the budget balance and net capital inflow? What is the relationship among the four? There are no government transfers. (Hint: net capital inflow equals the value of imports (IM) minus the value of exports \((X) .)\) GDP \(=\$ 1,000\) million \(\quad G=\$ 100\) million \(C=\$ 850\) million \(\quad X=\$ 100\) million \(T=\$ 50\) million \(I M=\$ 125\) million

Short Answer

Expert verified
Answer: In the open economy of Regalia, the level of investment spending (I) is $75 million, private savings (S) is $100 million, budget balance is -$50 million, and net capital inflow is $25 million.

Step by step solution

01

Find Investment (I)

To find the level of investment spending, we will use the first equation: GDP = C + I + G + (X - IM). Plugging in the given values, we get: \(1,000 = 850 + I + 100 + (100 - 125)\) This simplifies to: \(I = 1,000 - 850 - 100 - (-25) = 75\)
02

Find Private Savings (S)

To find private savings, we will use the second equation: S = Y (GDP) - C - T. Plugging in the given values, we get: \(S = 1,000 - 850 - 50 = 100\)
03

Find Budget Balance

To find the budget balance, we will use the third equation: Budget Balance = T - G. Plugging in the given values, we get: Budget Balance \(= 50 - 100 = -50\)
04

Find Net Capital Inflow

To find the net capital inflow, we will use the fourth equation: Net Capital Inflow = IM - X. Plugging in the given values, we get: Net Capital Inflow \(= 125 - 100 = 25\) To summarize: - Investment spending (I) = $75 million - Private savings (S) = $100 million - Budget balance = $-50 million - Net capital inflow = $25 million The relationship among these four variables can be derived from the national income identity for an open economy: \(S - I = (T - G) + (IM - X)\) Plugging in the obtained values, we get: \(100 - 75 = (-50) + 25\) \(25 = 25\) This verifies the relationship among private savings, investment spending, budget balance, and net capital inflow in the economy of Regalia.

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Most popular questions from this chapter

Explain the effect on a company's stock price today of each of the following events, other things held constant. a. The interest rate on bonds falls. b. Several companies in the same sector announce surprisingly higher sales. c. A change in the tax law passed last year reduces this year's profit. d. The company unexpectedly announces that due to an accounting error, it must amend last year's accounting statement and reduce last year's reported profit by \(\$ 5\) million. It also announces that this change has no implications for future profits.

For each of the following, is it an example of investment spending, investing in financial assets, or investing in physical assets? a. Rupert Moneybucks buys 100 shares of existing Coca-Cola stock. b. Rhonda Moviestar spends \(\$ 10\) million to buy a mansion built in the $1970 \mathrm{~s}$. c. Ronald Basketballstar spends \(\$ 10\) million to build a new mansion with a view of the Pacific Ocean. d. Rawlings builds a new plant to make catcher's mitts. e. Russia buys \(\$ 100\) million in U.S. government bonds.

Explain how a well-functioning financial system increases savings and investment spending, holding the budget balance and any capital flows fixed.

Boris Borrower and Lynn Lender agree that Lynn will lend Boris \(\$ 10,000\) and that Boris will repay the \(\$ 10,000\) with interest in one year. They agree to a nominal interest rate of \(8 \%,\) reflecting a real interest rate of \(3 \%\) on the loan and a commonly shared expected inflation rate of \(5 \%\) over the next year. a. If the inflation rate is actually \(4 \%\) over the next year, how does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off? b. If the actual inflation rate is \(7 \%\) over the next year, how does that affect Boris and Lynn? Who is better off?

How would you respond to a friend who claims that the government should eliminate all purchases that are financed by borrowing because such borrowing crowds out private investment spending?
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