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= = Problem 1. Twin Deficits A small open economy has potential GDP of 550. The government collects 20% of national income in taxes and initially keeps the budget balanced. There are no transfers or public debt. The consumption function is C 20 + 0.5YD where Yp is disposable income. The investment function is I = 580 10,000r. The net export function is NX = 85 5RER where RER is the real exchange rate. The world interest rate is pW = 4%. Net factor payments are NFP= -50. (A) Find the taxes and government spending. (Hint: T = 100) (B) Find the initial equilibrium: find savings S, investment I, current account CA, net export NX and the real exchange rate RER. Is there net capital inflow or net capital outflow? Is there trade surplus or trade deficit? (C) The government expands its spending by 100 through borrowing on the loanable funds market. Find the new equilibrium (S, I, CA, NX, RER). Is there a budget surplus or budget deficit now? Is there net capital inflow or net capital outflow? Is there a trade surplus or trade deficit? (D) On two diagrams (the loanable funds market and the foreign exchange market), show the initial situation and the new equilibrium. (E) Using plain English, explain how the economy transitions between the two equilibria. (F) How does this problem illustrate the concept of twin deficits? (You may want to read Chapter 5, section 5.5) = = Problem 1. Twin Deficits A small open economy has potential GDP of 550. The government collects 20% of national income in taxes and initially keeps the budget balanced. There are no transfers or public debt. The consumption function is C 20 + 0.5YD where Yp is disposable income. The investment function is I = 580 10,000r. The net export function is NX = 85 5RER where RER is the real exchange rate. The world interest rate is pW = 4%. Net factor payments are NFP= -50. (A) Find the taxes and government spending. (Hint: T = 100) (B) Find the initial equilibrium: find savings S, investment I, current account CA, net export NX and the real exchange rate RER. Is there net capital inflow or net capital outflow? Is there trade surplus or trade deficit? (C) The government expands its spending by 100 through borrowing on the loanable funds market. Find the new equilibrium (S, I, CA, NX, RER). Is there a budget surplus or budget deficit now? Is there net capital inflow or net capital outflow? Is there a trade surplus or trade deficit? (D) On two diagrams (the loanable funds market and the foreign exchange market), show the initial situation and the new equilibrium. (E) Using plain English, explain how the economy transitions between the two equilibria. (F) How does this problem illustrate the concept of twin deficits? (You may want to read Chapter 5, section 5.5)

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