Question

We are in a world with a real interest rate of 7%. The economy of Smoothiland is hit by a temporary shock to GDP of 200 million units at time T. The population of Smoothiland have a strong preference for consumption smoothing, and Smoothiland has an open economy.
1. By how much does consumption to fall in time T+1? (in millions, round to the closes decimal).
2. How much does the country have to borrow to maintain smooth consumption? (round to the closest decimal)

Answer 1

Answer:

1. 14.28 million units

2. The country has to borrow 200 million in order to maintain smooth consumption

Explanation:

1. Real interest rate = 7%

Temporary shock to GDP(Y) at Time(T)

= 200 million

Fall of consumption (T) in time T+1 =

So,

Y= C+rY

200=C+(0.07*200)

= C + 14

C = 200/14

= 14.28

Therefore,

Consumption will fall by 14.28 million units

2. The country has to borrow 200 million in order to maintain smooth consumption