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    Jonty Jenkins
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    1) The government spending multiplier is smaller in an open economy (1.25) than a closed economy (1.67) due to import leakage. 2) With two symmetric countries, the multiplier is larger (1.33) as government spending in one country increases output and exports in the other, further increasing the initial country's output. 3) If both countries set government spending to 100, the model shows each country's output will be 400.

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    1) The government spending multiplier is smaller in an open economy (1.25) than a closed economy (1.67) due to import leakage. 2) With two symmetric countries, the multiplier is larger (1.33) as government spending in one country increases output and exports in the other, further increasing the initial country's output. 3) If both countries set government spending to 100, the model shows each country's output will be 400.

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    28 views9 pages

    Week10 Examplesolution PDF

    Uploaded by

    Jonty Jenkins
    1) The government spending multiplier is smaller in an open economy (1.25) than a closed economy (1.67) due to import leakage. 2) With two symmetric countries, the multiplier is larger (1.33) as government spending in one country increases output and exports in the other, further increasing the initial country's output. 3) If both countries set government spending to 100, the model shows each country's output will be 400.

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    of 9

    Example #10: problem

    Setup: Consider the following two-country economy. The real


    exchange rate is xed and equal to 1. Domestic consumption,
    investment and taxes are given by
    C = 110 + 0.4(Y − T ), I = 40, T = 25
    Import and exports are given by
    IM = 0.2Y, X = 0.2Y ∗
    (asterisks denote foreign variables).
    (a) Solve for domestic output in terms of G and Y ∗ .
    (b) How does the government purchases multiplier compare to the
    closed economy case?
    (c) Suppose both countries are symmetric, just with asterisks
    reversed. Solve for output in each country in terms of G, G∗ .
    (d) How does the multiplier compare to the one you found in (b)?
    (e) Suppose both countries have G = G∗ = 100. Calculate Y, Y ∗ .
    Example #10: solution
    • Part (a): The national income accounting identity is
    Y = C + I + G + X − IM

    • Plugging in what we know


    Y = 110 + 0.4(Y − 25) + 40 + G + 0.2Y ∗ − 0.2Y

    • Solving for Y gives


    1  
    Y = 110 − 0.4(25) + 40 + G + 0.2Y ∗
    1 − 0.4 + 0.2

    1  
    = 140 + G + 0.2Y ∗
    0.8

    = 175 + 1.25G + 0.25Y ∗


    Example #10: solution
    • Part (b): In this open economy we have the multiplier
    dY 1 1
    = = = 1.25
    dG 1 − 0.4 + 0.2 0.8

    • If the economy was closed, we would have the multiplier


    1 1
    = = 1.67
    1 − 0.4 0.6

    • Hence the open economy multiplier is smaller. In the closed


    economy there is no `leakage' to import demand.
    Example #10: solution

    • Part (c): We have for the domestic economy


    Y = 175 + 1.25G + 0.25Y ∗ (1)

    • Since the foreign country is symmetric, just reverse the asterisks


    Y ∗ = 175 + 1.25G∗ + 0.25Y (2)

    • We need to solve these two equations in two unknowns


    Example #10: solution
    • Part (c) cont: Plug equation (2) into equation (1)
     
    ∗
    Y = 175 + 1.25G + 0.25 175 + 1.25G + 0.25Y

    • Solve for Y
    1   
    Y = 175 + 1.25G + 0.25 175 + 1.25G∗
    1 − (0.25)(0.25)

    1  
    = (1.25)(175) + 1.25G + (0.25)(1.25)G∗
    1 − 0.0625

    = 233.33 + 1.33G + 0.33G∗

    • By symmetry, also have


    Y ∗ = 233.33 + 1.33G∗ + 0.33G
    Example #10: solution

    • Part (d): Now the government purchases multiplier is


    dY
    = 1.33
    dG

    • This is larger than the multiplier (= 1.25) from part (b)

    • In (b) we held Y ∗ xed. But here when we compute the multiplier


    we are also taking into account the indirect eect of G on Y ∗ on
    exports X back on to domestic Y
    Example #10: solution
    • Part (d) cont: Alternative approach. Start with
    Y = C + I + G + X − IM
    so
    dY dC dX d(IM )
    = +0+1+ −
    dG dG dG dG
    with
    dC dY
    = (0.4)
    dG dG

    dX dY ∗ dY
    = (0.2) = (0.2)(0.25)
    dG dG dG

    d(IM ) dY
    = (0.2)
    dG dG
    Example #10: solution
    • Part (d) cont: Plugging all these in
    dY dY dY dY
    = (0.4) + 1 + (0.2)(0.25) − (0.2)
    dG dG dG dG

    • Solving for the multiplier


    dY 1 1
    = = = 1.33
    dG 1 − 0.4 − (0.2)(0.25) + 0.2 0.75

    • Same answer, but here we see clearly that the multiplier is larger
    because of the change in Y ∗ on exports X back on to domestic Y .
    Example #10: solution
    • Part (e): If G = G∗ = 100 we simply have
    Y = 233.33 + 1.33G + 0.33G∗

    = 233.33 + 1.33(100) + 0.33(100)

    = 400

    • And because of the symmetry also


    Y ∗ = 400

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