Stowe Automotive is considering an offer from Indula to build a plant making automotive parts for use in that country. In preparation for a final decision, Stowe’s economists have been hard at work constructing a basic econometric model for Indula to aid the company in predicting future levels of economic activity. Because of the cyclical nature of the automotive parts industry, forecasts of future economic activity are quite important in Stowe’s decision process.
Corporate profits (Pt−1) for all firms in Indula were about $100 billion. GDP for the nation is composed of consumption C, investment I, and government spending G. It is anticipated that Indula’s federal, state, and local governments will spend in the range of $200 billion next year. On the basis of an analysis of recent economic activity in Indula, consumption expenditures are assumed to be $100 billion plus 80 percent of national income. National income is equal to GDP minus taxes T. Taxes are estimated to be at a rate of about 30 percent of GDP. Finally, corporate investments have historically equaled $30 billion plus 90 percent of last year’s corporate profits (Pt−1).
a. Construct a five-equation econometric model of the state of Indula. There will be a consumption equation, an investment equation, a tax receipt equation, an equation representing the GDP identity, and a national income equation.
b. Assuming that all random disturbances average to zero, solve the system of equations to arrive at next year’s forecast values for C, I, T, GDP, and Y.