Suppose a small open economy is characterised by the following equations/information:
Y =6K^{0}L^{1-α}
K_{0} = 30,000
L_{0} = 10,000
I = 4,000 - 200r, where r is measured in percentage points (i.e. 2 means 2%)
T = 3,500
C = 10,390 + 0.90(Y -T) - 700r
NX = 600 - 650ε where ε = # of foreign goods per unit of domestic goods.
M^{d} = P × L(Y, r) = P(0.6Y - 300r)
M^{S} = 75,000
On average, labour earns 50% of GDP as income. Keep all of your calculations to at least four decimal places. Show the steps in your calculations (otherwise full marks can NOT be given).
Note the economy in question:
- Is a small open economy
- There is perfect financial capital mobility
- There is no risk premium (for this country)
- This country presently has a government budget surplus of 500
A) If this country has balanced trade in long-run equilibrium solve for the long-run equilibrium levels of the world real interest rate, national saving and domestic investment.
B) If the foreign price level is equal to 1.16 then solve for the long-run level of the domestic price level, real exchange rate and nominal exchange rate.
C) Suppose a trading partner increases trade barriers against all exports from other countries. As a result autonomous net exports drops by 10%. Solve for the resulting long-run levels of domestic investment, net exports, the domestic price level, the real exchange rate and nominal exchange rate. Explain any additional assumptions made.
D) Suppose the government does not like the outcome in Part C. The government decides that it wants to keep the real exchange rate fixed at the initial long-run equilibrium level, from part B (prior to the shock). Should it use changes in government spending or the money supply in order to achieve this goal? Explain. Solve for the resulting long-run levels of domestic investment, net exports, the domestic price level, the real exchange rate and nominal exchange rate.