Suppose that net exports, NXt, are determined by the following expression:

NXt/Ȳt = αNX−βNX(rt−rt) (6),

where t is potential GDP and rt−rt is the difference between the domestic and the foreign real interest rate.

a. Explain the intuition behind expression (6).

b. Modify the IS curve below so that (6) is taken into account.

t= α − β (rt−r̃)

It specifies a negative relationship between short-run output, Ỹt, and the real interest rate, rt

c. Explain how a decrease in the domestic real interest rate affects short-run output in this economy.

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