ECON110 Tutorial 12 Chapter 17 Problem No. 1 and 4

Problem 1 Current Account The current account records all transaction of goods and services or a direct transfer of income. Conventions: Transactions that bring in foreign exchange are recorded as credits. Transactions that lead to an outflow of foreign exchange are recorded as debits.

Capital Account The capital account records all transactions that involve the acquisition of either an asset or a liability. Convention: New liabilities  credit items (Why?) Acquisition of assets  debit items (Why?)

The current and capital account balances sum to zero. CAB + KAB = 0

a. An Australian exporter sells software to Israel. She uses the Israeli shekels received to buy stock in an Israeli company. – Software sale to Israel  Current account credit – Stock purchase  Capital account debit

b. An East Timorese firm uses proceeds from its sale of oil to Australia to buy Australian government bonds. In Australian BoP: – Oil purchase  CA debit (CA deficit) – Bonds purchase (by East Timorese firm)  KA Credit (KA surplus) – CAB + KAB = 0

c. An East Timorese firm uses proceeds from its sale of oil to Australia to buy oil-drilling equipment from an Australian firm. – Oil purchase  current account debit (deficit) – Bond purchase  current account credit (surplus) – CAB + KAB = 0

Problem 4. A country’s domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations: S = r I = 2000 – 4000r KI = r

a. Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment, and the real interest rate r – r = 2000 – 4000r 2000r r r = 2000 – r = 600 r = 600/12000 = 0.05 Then S = r = (0.05) = 1600 I = 2000 – 4000r = 2000 – 4000(0.05) = 1800 KI = r = (0.05) = 200 Equilibrium: S + KI = I

b. Repeat Part a), assuming that desired national saving declines by 120 at each value of real interest rate. What effect does a reduction in domestic saving have on capital inflows? Now S = (1500 – 120) r = r Equilibrium: S + KI = I r r = r r = 0.06 S = 1500 KI = 260 I = 1760

c. Concern about the economy’s macroeconomic policies causes capital inflows to fall sharply so that now KI = r. Repeat Part (a). What does a reduction in capital inflows do to domestic investment and the real interest rate? r = 0.10 S = 1700 KI = -100 I = 1600 Reduction in capital inflows Domestic investment decreases Real interest rate increases Capital inflows augment the domestic saving pool, increasing the funds available for investment, while capital outflows reducing the amount of saving available for investment.

Last Test A tax cut – Disposable income (Y-T) increases – Consumption C = C 0 + c(Y-T) increases – Aggregate demand increases: AD shifts right, the economy moves to A. – At A, actual output higher than potential output: Y 1 > Y*, expansionary gap. – If the CB does nothing, inflation increases: SRAS shifts up to SRAS’ – In the long run, inflation increases to a higher level and output returns to potential level, the economy is at C. – If the CB doesn’t want the inflation rate to increase, the CB could shifts up its policy reaction function (PRF) while the economy is at B. Higher interest rate would make the AD curve shifts back from AD’ to AD. So the economy returns to the initial equilibrium at A.

Yn Y’ π π’π’ A B C Inflation Output