Nguyễn Thị Hương Giang - HS160858 - IB1704

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:
Private saving = Y - T - C = 5,500
Public saving = T - G = 2,800
National saving = Private saving + Public saving = 8,300 = Investment

8,300 = 9,300 - 100i → i = 10%

→ Private saving = 5,500; Public saving = 2,800; National saving = Investment = 8,300; The
equilibrium real interest rate = 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 saving 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 budget deficit?
d) Suppose MS increases so the supply for LF increases to match the amount of budget deficit.
Illustrate this on the graph. What are the consequences of this action if velocity of money is
constant and output level (real GDP) does not change?

Answer:
a.

i S
(% (LF2)
S
)
i (LF1
2 )

i
1
D
(LF)

LF3 LF2 LF
LF1 ($)

Supply of LF decrease, S1 shift left to S2 (by 200 billion)

Interest rate rises: i2 > i1
An increase in interest rates reduces investment
Rising interest rates promote saving, so private savings increase

b. Public saving decrease by 200 billion, LF1 - 200

Private saving increase because interest rates rise
National saving = investment decrease less than 200 billion
LF1 -> LF1 - 200 -> LF2
 So, LF decrease less than 200 billion
c.

i
(
% S S
) (LF2 (LF1)
)

D
(LF)
LF
($)

LF2 = LF1 - 200

Interest rates in this part is greater than part a
Private saving is extremely important. We can clearly see this by comparing the interest rate
increase of part a with that of part c. Part a has a lower interest rate than part c because the supply
for LF of part a is
national saving = private saving + public saving, the supply for LF of part c is just public saving.
So when there is a budget deficit, the supply for LF of part c will shift to the left exactly equal to
the budget deficit. In part a, the supply for LF shifts to the left, smaller than the budget deficit.
d.

i S2
(% S3
)

i
1

i LF
2 ($)
LF3 = LF1 = LF2 + 200
S2 shifts to S3 = S1
Money supply increase 200 billion
Delta M = 200 : LF2 x 100%
MxV=QxP
V and Q constant
M increase 200 : LF2 x 100%, so P increase 200 : LF2 x 100%
Question 3: You deposit 500 million VND at the interest rate is 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:
Saving interest rate when depositing 500 million is: 500 x 10% = 50 million VND
Tax expense = Saving interest rate x Tax rate
= 50 x 20% = 10 million VND
Nominal net income = Total nominal revenue - Total costs
= 50 - 10 = 40 million VND = Nominal after-tax income
Real before-tax income = 500 x 5% = 25 million VND
Real after-tax net income = 25 - 10 = 15 million VND
Real interest rate = Nominal interest rate - Inflation rate
= 10% - 5% = 5%
Nominal after-tax interest rate = Nominal interest rate ( 1 - Tax rate)
= 10% ( 1 - 20%) = 8%
After-tax real interest rate = Nominal after-tax interest rate - Inflation rate
= 8% - 5% = 3%
Question 4: Suppose a Home country’s economy can produces 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 use 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 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:
$ 10−$ 8
a. The inflation rate of clothes = x 100% = 25%
$8
$ 5−$ 4
The inflation rate of fuel = x 100% = 25%
$4

b.
A piece of clothes A liter of fuel

Home country 4 hours 2 hours

Foreign country 5 hours 10 hours

Home country has an absolute advantage in producing clothes and fuel. Because it takes less time
to produce clothes and fuel in Home country than in Foreign country.

c. Both economies can supply a total of 4000 hours of labor

Home country: 4000 hours can produce 1000 clothes
4000 hours can produce 2000 fuel
 clothe
s

100
0

0
fuel
200
0

Foreign country: 4000 hours can produce 800 clothes

4000 hours can produce 400 fuel
clothes

800

0
400 fuel

d. Opportunity Cost:

A piece of clothes A liter of fuel

Home country 2 4
= 0.5 fuel = 2 clothes
4 2

Foreign country 10 5
= 2 fuel = 0.5 clothes
5 10

e. Home country has a comparative advantage in producing fuel. Because in a Home country to
produce a piece of clothes, it takes 0.5 hours to produce fuel while in a Foreign country it only
takes 2 hours to produce fuel.
 Foreign country has a comparative advantage in producing clothes. Because in Home country to
produce a piece of fuel, it takes 2 hours to produce clothes while in Foreign country it only takes
0.5 hours to produce clothes.

f. Quantity of output of 2 countries to produce 2 fields before and after trade:

Before trade After trade

Clothes Fuel Clothes Fuel

Home 2000 h 2000 h 4000 h x 40 % 4000 h x 60 %

= 500 = 1000 = =
country 4h 2h 4h 2h
400 1200

Foreign 2000 h 2000 h 4000 h x 60 % 4000 h x 40 %

= 400 = 200 = =
country 5h 10 h 5h 10 h
480 160

g.

Home country Clothes Fuel

Production 400 1200

- Export - 100

+ Import + 50

= Consume after trade 450 1100

- Consume before trade 500 1000

Gains from trade -50 100

Foreign country Clothes Fuel

Production 480 160

- Export - 50

+ Import + 100

= Consume after trade 430 260

- Consume before trade - 400 - 200

Gains from trade 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:
M = $550 billion; P x Y = $11 trillion; Y = $5.500 trillion
a. Price level = P = $2 trillion
P XY
Velocity of money = V = = $20 billion
M

b. If M and V remain constant, and Y increases 20%

Because M x V = P x Y ⇒ P has to fall by 20%

→ Nominal GDP is unchanged.

c. To keep the price level stable, the Central Bank must in increase the money supply by 20%,
matching the increase in real GDP.
Because velocity is unchanged, the price level will be stable.

→ 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 23%.

→ M x V will rise 23%, causing P x Y to rise 23%, with a 3% increase in prices and a 20%
rise

in real GDP.

→ 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:
There are many costs of inflation, volatility, and uncertainty that can lead to lower investment and lower
economic growth. Look at Zimbabwe's hyperinflation, excessive inflation that causes domestic prices to
rise faster than wages and income levels. So 1 million Zimbabwe dollars can only buy 1 chicken or
sometimes 1 loaf of bread. So the cost of inflation is that people are sometimes unable to buy needed
goods. A booming, unsustainable economy is also a cost of inflation. Because of high inflation, the
economy is not sustainable and will sometimes lead to an economic recession. Also from Zimbabwe's
hyperinflation, we see that the currency is depreciated, and worthless. When the currency depreciates,
people will change to pay with other things, there will be a 'bargain economy'. Not only that, the cost of
inflation will also make the country riskier because sometimes we cannot predict or do not adjust inflation
which will lead to many negative effects.