Question

Consider two open economies in which the real exchange rate is fixed and equal to one. Consumption, investment, government spending, taxes, imports and exports are given by equations below for each economy. Variables with * denote values for the foreign economy.

Domestic Economy: C= 12 + 0.8 (Y-T) I= 8 G= 10 T=11 IM= 0.2Y EX= 0.2Y*

Foreign Economy: C*= 12+ 0.8 (Y*-T*) I*=8 G*=10 T*=11 IM*= 0.2Y* EX= 0.2Y

a) Solve for the equilibrium output in the domestic economy, Y, and the foreign economy, Y*

b) What is the multiplier for each country?

c) Assume the domestic government, G, has a target level output of 125. Assuming that the foreign government does not change G*, what is the increase in G necessary to achieve the target output in the domestic economy?

d) Suppose each government has a target level output of 125 and that each government increases government spending by the same amount. What is the common increase in G and G* necessary to achieve the target output in both countries?

Answer 1

Economy a) Domestic 1: с+ + Go t E X - 1M Y"- o:2 Y (Y- )+ o2 30 O 8 o :2 Y* E 2\'2 + O'6 y 21 2 53+ O5 Y* Foreign :Riaorwoo Ex* - IM* Y * : 53 + symmetrical, Y- Y* C23 As amd 53 10 6 - 2'5 Muuti plier 1-o 8+0 2 b) Domestic chamges Ga to G Suppose AGI G AG 53+ AG t 53.+ 0 5 Now Y [25 , Y* : (se)s (25 = 5 3 + AG o5 { 25 = \\O'75 + A G 14:25 AGG = AG = AG* d) In case 53t A G AG = 12 5 x o.5 - 5 3 = a'5