Question 1: Economists in FPT Land, a closed economy, have collected the

following information about the economy for a particular year:

Y = 20,000 C= 9,000 T = 5,500 G=2,700
The economists also estimate that the investment function is:
I = 9,300 – 100i,
where i is the country's real interest rate, expressed as a percentage.
Calculate private saving, public saving, national saving, investment, and the
equilibrium real interest rate.
● Answer:
1. Private saving is equal to (Y - C - T) = 20,000 - 9,000 - 5,500 = 5,500
2. Public saving is equal to (T - G) = 5,500 - 2,700 = 2,800
3. National saving is equal to (Y - C - G) = 20,000 - 9,000 - 2,700 = 8,300
4. Investment is equal to saving = 8,300
5. The equilibrium interest rate is found by setting investment equal to
2,300 and solving for r:
8,300 = 9,300 - 100i
100i=9,300 - 8,300
100i = 1000
i = 10%

Question 2: Because of social distancing, taxes are not enough to cover all public
spending so this year, the government borrows 200 billion VND to support
people from the Covid pandemic.
a) Illustrate on the graph. How is the new interest rate compared to before? How
does this affect Investment and Private saving?
b) Does LF decrease by exactly 200 billion? Why/why not?
c) Draw the situation in part a) when there’s no private savings so money supply
is the only supply for LF (vertical supply). How is the interest change
compared to part a. Comment on the importance of private saving, especially
when there is a budget deficit?
d) Suppose MS increases so the supply for LF increases to match the amount of
budget deficit. Illustrate this? What are the consequences of this action if
velocity of money is constant and output level (real GDP) does not change?
● Answer:
a, Borrow 200 billion VND => T-G <0 => Budget Deficit
=> Supply of LF decrease and shift left
=> IR increases: I1 -> I2

- Private saving:
+ IR increase -> saving is more attractive
+ A higher budget deficit means that they are just going to own more taxes
in the future to pay off all that government borrowing, so they will start
saving now
=> Private saving increase
- Investment
=> Because of Budget Deficit, T-G <0 => Public Saving decrease => National
Saving
b, LF decreased by less than 200 billion because national saving is the source
of the supply of loanable funds: public saving, private saving are included by
national saving do besides affection of public saving is private saving.
Therefore, private savings will partially offset the decrease in LF.
 c,

- IR increase more than IR in part a

- The importance of private saving, especially when budget deficit:
● private households might shift their saving to offset government saving
or borrowing
● in the national saving and investment identity, any change in budget
deficits or budget surpluses would be partially offset by a corresponding
change in private saving
=> So private saving does increase to some extent when governments run large
budget deficits, and private saving falls when governments reduce deficits or
run large budget surpluses. However, the offsetting effects of private saving
compared to government borrowing are much less than one-to-one.
d,

Quantity equation: P.Y=M.V

 if V is constant and Y does not change => causes the price level to change by
the same change in the money supply.

Question 3: You deposit 500 million VND at the interest rate of 10% per year.
Tax rate is 20% and applied on interest income from deposit. You expect the
inflation rate next year to be 5%.
Calculate tax expense, nominal net income = nominal after-tax income, real before-
tax income, & real after-tax net income
Calculate the nominal after-tax interest rate, real interest rate, and after-tax real
interest rate
● Answer:
+ Deposit: 500 million VND
+ Interest rate: 10%
+ Nominal before-tax income: 500 x 10% = 50m VND
1. Tax expense: 50 x 20% = 10m VND
2. Nominal net income = Nominal after-tax income:
50 - 10= 40m VND
3. Real before-tax income: 500 x (0,1- 0,05) = 25m VND
4. Real after-tax net income: 500 x (0.1- 0,05) - 10 = 15m VND
5. Nominal after-tax interest rate: 10 - (0,2 x 10) = 8%
6. Real interest rate: 10% - 5% = 5%
7. After-tax real interest rate: 5% - (0,2 x 10) = 3%

Question 4: Suppose a Home country’s economy can produce clothes and fuel.
Unit labor requirement in Home country for a piece of clothes is 4 hours, while it
is 5 hours in Foreign country. Unit labor requirement in Home country for a liter
of fuel is 2 hours, while it is 10 hours in Foreign country. Both economies can
supply a total of 4000 hours of labor. The price of a piece of clothes is $8 and the
price of a liter of fuel is $4. A basket of living expenses contains a piece of clothes
and a liter of fuel.
a) Suppose the price of clothes is now $10 per piece and the price of fuel is now
$5. Calculate the inflation rate using the basket value.
b) Which sector in which country has absolute advantage?
c) Draw the possible production frontiers of the two countries
d) Calculate the opportunity cost ratio for each sector in each country. What do
these numbers mean?
e) Which country has comparative advantage for which good?
f) Before trade, both countries used half of labor hours to produce in each sector.
After two economies open for trade, Home country uses 60% of total labor to
produce fuel and the rest for clothes, Foreign country uses 60% of the total
labor to produce clothes and the rest for fuel. Calculate the number of outputs
before and after trade.
g) Home country exports 100 liters of fuel and imports 50 pieces of clothes.
Calculate gains of trade.
● Answer:
a,
- Basket cost before: 8+4=12
- Basket cost now: 10+5 = 15
- CPI: 15/12 x100=125
=> Inflation rate: (125 -100) /100=25%
b, The host country has an absolute advantage in both textile and fuel
production because it uses fewer inputs than foreign countries.
c,
Clothes

1000

2000
Fuel
Home country
 Clothes

800

400 Fuel
Foreign Country

d, Home country:
- Fuel: 1000/2000 = 0,5
- Clothes: 2000/1000 = 2
=> The home country has to exchange 0,5 clothes for producing a fuel and 2
fuel for producing a clothes
Foreign country:
- Fuel: 800/400 = 2
- Clothes: 400/800 = 0,5
=> The home country has to exchange 2 clothes for producing a fuel and 0,5
fuel for producing a clothes
e,
- Home country has comparative advantage for fuel because its
opportunity cost is less than Foreign country (0,5 < 2)
- Foreign country has comparative advantage for clothes because its
opportunity cost is less than Home country (0,5 <2)
f,

Home Foreign
Country country

Clothes Fuel Clothes Fuel

Before trade 500 1000 400 200

After trade 400 1200 480 160

g,
 Home country Foreign
Clothes Fuel Clothes Fuel

Trade +50 -100 -50 +100

After-trade 450 1100 430 260
output
Gains -50 100 30 60

Question 5: Suppose that this year's money supply is $550 billion, nominal GDP
is $11 trillion, and real GDP is $5.5 trillion.
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant, and the economy's output of goods and
services rises by 20 percent each year. What will happen to nominal GDP and
the price level next year if the Central Bank keeps the money supply constant?
c. What money supply should the Central Bank set next year if it wants to keep
the price level stable?
d. What money supply should the Central Bank set next year if it wants inflation
of 3 percent?
● Answer:
a. (price level) x (real GDP) = P x Y = $11,000 = Nominal GDP
Where Y = real GDP = $5,500
=> Price level = Nominal GDP/ real GDP = $11,000/$5,500 = 2
Because (money supply) x (velocity) = (price level) x (real GDP)
=> V = (P x Y) / M = $11,000/ $550 = 20
b. If velocity and money supply unchanged and Real GDP rises by 20%,
besides we have M x V = P x Y so nominal GDP must decrease by 20%
=> Nominal GDP remains unchanged
c. To keep the price level stable, the Central Bank needs to increase 20%
corresponding to the increase of real GDP. Then the velocity is constant,
the price will be stable.
New MS = 120% x 550 billion = 660 billion
 d. If the Central Bank wants inflation to be 3%, it will need to increase the
money supply by 23%.
=> M x V will increase by 23%, making P x Y will also increase by
23% , with a price increase of 3% and real GDP by 20%
New MS = 123% x 550 billion = 676.5 billion

Question 6: What are the costs of inflation? Relate these costs during the
hyperinflation in Zimbabwe.

Reference: https://www.nytimes.com/2008/10/02/world/africa/02zimbabwe.html

● Answer:
- People couldn’t afford basic goods: Zimbabwe had the worst of
both worlds – prices rising faster than wages and incomes. People
became “poverty billionaires’ It was no good having a salary of
One billion dollars if a loaf of bread cost two billion.
- No credit available: The entire financial system became
undermined, banks closed and were unwilling to lend any money.
Due to rising prices, the value of debt could be soon wiped out.
- Menu costs: With inflation almost doubling through the day,
anyone who received money had to exchange into foreign currency
or spend straight away. Bus commutes were one price in the
morning, and much more expensive on the way back. People had to
spend time adjusting prices, but more importantly get rid of
Zimbabwean currency as soon as you received it.
- Switch to a barter economy: With money becoming worthless,
people found ways around the official economy, paying for goods
in kind (e.g. using agricultural produce to get a haircut) The
problem is the barter economy is only useful if you have goods to
exchange. Business increasingly switched to the use of foreign
currency – the US dollar as the only way to survive inflation.
- Lost savings: Anyone with savings lost everything – unless they
were able to exchange with foreign currency. Even people with
assets and property often saw the value shrink. Foreign exchange
controls make it very hard to take money out of the country.
- Damage to business confidence: The extent of hyperinflation and
fall in output disrupted normal economic activity and saw
Zimbabwe GDP shrink. It affects investors for a long time.