East West University

ECO 102 (4) | Spring’ 2022;

Assignment – II
Due on 29 March, 2022

Saving, Investment and the Financial System

1. Economists in Funland, a closed economy, have collected the following information

about the economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economists also estimate that the investment function is:

I = 3300 - 100r

where r 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.

(10 marks)

2. Suppose the government borrows $20 billion more next year than this year.

a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate
rise or fall?
b. What happens to investment? To private saving? To public saving? To national
saving? Compare the size of the changes to the $20 billion of extra government
borrowing.
c. How does the elasticity of supply of loanable funds affect the size of these
changes?
d. How does the elasticity of demand for loanable funds affect the size of these
changes?
e. Suppose households believe that greater government borrowing today implies
higher taxes to pay off the government debt in the future. What does this belief
do to private saving and the supply of loanable funds today? Does it increase or
decrease the affects you discussed in parts (a) and (b)?

(20 marks)

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Aggregate Demand and Aggregate Supply (12 marks)

3. Suppose an economy is in long-run equilibrium.

a. Use the model of aggregate demand and aggregate supply to illustrate the initial
equilibrium (call it point A). Be sure to include both short-run and long-run
aggregate supply.
b. The central bank raises the money supply by 5 percent. Use your diagram to show
what happens to output and the price level as the economy moves from the initial
to the new short run equilibrium (call it point B).
c. Now show the new long-run equilibrium (call it point C). What causes the
economy to move from point B to point C?
d. According to the sticky-wage theory of aggregate supply, how do nominal wages
at point A compare to nominal wages at point B? How do nominal wages at point
A compare to nominal wages at point C?
e. According to the sticky-wage theory of aggregate supply, how do real wages at
point A compare to real wages at point B? How do real wages at point A compare
to real wages at point C?
f. Judging by the impact of the money supply on nominal and real wages, is this
analysis consistent with the proposition that money has real effects in the short
run but is neutral in the long run?

Aggregate Expenditure and Equilibrium Output (8 marks)

4. You are given the following data concerning Freedonia, a legendary country:
1. Consumption function: C = 200 + 0.8Y
2. Investment function: I = 100
3. AE = C + I
4. AE = Y
a. What is the marginal propensity to consume in Freedonia, and what is the
marginal propensity to save?
b. Graph equations (3) and (4) and solve for equilibrium income.
c. Suppose equation (2) is changed to (2´) I = 110.What is the new equilibrium level
of income? By how much does the $10 increase in planned investment change
equilibrium income? What is the value of the multiplier?
d. Calculate the saving function for Freedonia. Plot this saving function on a graph
with equation (2). Explain why the equilibrium income in this graph must be the
same as in part b.

Best of luck!

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