Small Open Economy ModelConsider the Small Open Economy model studied in class. Answer the following questions by assuming that the purchasing power parity (PPP) holds. (a)Suppose that future total factor productivity (TFP) increases (e.g., becauseit is expected that a new invention will become available in the future). Which are theeffects of this shock on the equilibrium values of the real interest rate and output?Use the equilibrium diagram for the current goods market to answer this question.(b)How will the composition of output be affected by the future TFP shockdescribed in Part (a)? Show that the future TFP shock increases the current accountdeficit.(c)Suppose that the government of this small open economy wishes toreduce the current account deficit. To achieve that goal, the government plans tochange the level of current public spending (i.e., G, using the notation we applied inclass). Should the government increase or decrease current public spending? Justifyyour answer using a new equilibrium diagram for the current goods market.(d)the government changes public spending in order to reduce the current accountdeficit (as analysed in Part (c)). What would be the effects of this policy on theAssume that the country has a flexible exchange rate regime, and thatnominal exchange rate and on the domestic price level? Justify your answer usingthe equilibrium diagram for the current money market.

A small open economy, shortened to SOE, is an economy that takes part in global exchange, however is…

(a) it is expected that a new invention will become available in the future). Which are the effects of this shock on the equilibrium values of the real interest rate and output? Use the equilibrium diagram for the current goods market to answer this question. Suppose that future total factor productivity (TFP) increases (e.g., because (b) described in Part (a)? Show that the future TFP shock increases the current account How will the composition of output be affected by the future TFP shock deficit. (c) reduce the current account deficit. To achieve that goal, the government plans to change the level of current public spending (i.e., G, using the notation we applied in class). Should the government increase or decrease current public spending? Justify your answer using a new equilibrium diagram for the current goods market. Suppose that the government of this small open economy wishes to

(a) it is expected that a new invention will become available in the future). Which are the effects of this shock on the equilibrium values of the real interest rate and output? Use the equilibrium diagram for the current goods market to answer this question. Suppose that future total factor productivity (TFP) increases (e.g., because (b) described in Part (a)? Show that the future TFP shock increases the current account How will the composition of output be affected by the future TFP shock deficit. (c) reduce the current account deficit. To achieve that goal, the government plans to change the level of current public spending (i.e., G, using the notation we applied in class). Should the government increase or decrease current public spending? Justify your answer using a new equilibrium diagram for the current goods market. Suppose that the government of this small open economy wishes to

ENGR.ECONOMIC ANALYSIS

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ISBN:9780190931919

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Chapter1: Making Economics Decisions

Section: Chapter Questions

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Question

Small Open Economy Model

Consider the Small Open Economy model studied in class. Answer the following questions by assuming that the purchasing power parity (PPP) holds.

(a)
Suppose that future total factor productivity (TFP) increases (e.g., because
it is expected that a new invention will become available in the future). Which are the
effects of this shock on the equilibrium values of the real interest rate and output?
Use the equilibrium diagram for the current goods market to answer this question.
(b)
How will the composition of output be affected by the future TFP shock
described in Part (a)? Show that the future TFP shock increases the current account
deficit.
(c)
Suppose that the government of this small open economy wishes to
reduce the current account deficit. To achieve that goal, the government plans to
change the level of current public spending (i.e., G, using the notation we applied in
class). Should the government increase or decrease current public spending? Justify
your answer using a new equilibrium diagram for the current goods market.
(d)
the government changes public spending in order to reduce the current account
deficit (as analysed in Part (c)). What would be the effects of this policy on the
Assume that the country has a flexible exchange rate regime, and that
nominal exchange rate and on the domestic price level? Justify your answer using
the equilibrium diagram for the current money market.

Definition Definition Value of one unit of currency in terms of goods and services. Purchasing power refers to the ability of money to purchase goods and services at a particular point of time. As price levels in the economy increase, the purchasing power of one unit of currency decreases and vice versa.

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