A small open economy has perfect financial capital mobility, no risk premium, a flexible exchange rate and can be described by the following: C = 4000 + 0.75(Y - T) Y(FE) = 75,000 I = 5000 - 1000r MS = M = 21480 G = 6000 Real money demand = ( 0.25Y - 2500r ) Gov't Budget surplus = 0 Nominal price level = 1.20 World real rate of interest = 0.06 NOTE: Keep your answers to 2 decimals. Part A) Derive the IS* curve and the LM* curves. Solve for the initial short-run equilibrium, levels of real GDP, nominal exchange rate, consumption, investment and the trade balance. Part B) Suppose the government implements a tax cut of 64. Solve for the new short-run equilibrium, levels of real GDP, nominal exchange rate, consumption, investment and the trade balance. Part C) Suppose the government decides not only cut taxes by 64 but they also order the central bank to fix the exchange rate at 1.00. Explain in words and with the aid of a single Y-e diagram what impact this will have on the short-run levels of real output, the nominal money supply, foreign currency reserves and the trade balance. Don't forget to clearly label the equilibria from parts B & C in your diagram.
A small open economy has perfect financial capital mobility, no risk premium, a flexible exchange rate and can be described by the following:
C = 4000 + 0.75(Y - T)
Y(FE) = 75,000
I = 5000 - 1000r
MS = M = 21480
G = 6000
Real money demand = ( 0.25Y - 2500r )
Gov't Budget surplus = 0
Nominal price level = 1.20
World real rate of interest = 0.06
NOTE: Keep your answers to 2 decimals.
Part A) Derive the IS* curve and the LM* curves. Solve for the initial short-run equilibrium, levels of real
Part B) Suppose the government implements a tax cut of 64. Solve for the new short-run equilibrium, levels of real GDP, nominal exchange rate, consumption, investment and the trade balance.
Part C) Suppose the government decides not only cut taxes by 64 but they also order the central bank to fix the exchange rate at 1.00. Explain in words and with the aid of a single Y-e diagram what impact this will have on the short-run levels of real output, the nominal money supply, foreign currency reserves and the trade balance. Don't forget to clearly label the equilibria from parts B & C in your diagram.
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