1. If hypothetically, the Japanese bonds give 15 percent interest rate against 10 percent interest rate of Euro bonds, and the expected rate of depreciation of the yen is 10 percent. Which bond will investors buy? By how much shall the yen depreciate so that uncovered interest parity holds? You can assume Japan is the domestic country.

2. Consider the following open economy. The real exchange rate is fixed and equal to one. Consumption, investment, government spending, and taxes are given by: C= 10+ 0.8(Y-T) I=10 G=10 T=10 Imports and exports are given by: Q= 0.3Y X= 0.3Y * Where an asterisk denotes a foreign variable. a. Solve for equilibrium income in the domestic economy, given Y * . What is the multiplier in this economy? If we were to close the economy (so that exports and imports were equal to zero), what would the multiplier be? Why are the two multipliers different? b. Assume the foreign economy has the same equations as the domestic economy (remove the asterisk from all the variables with an asterisk, and add an asterisk to all the variables without an asterisk). Use the two sets of equations to solve for the equilibrium income of each country. What is the multiplier for each country now? c. Assume both countries have a target level of output of 125. What is the increase in G necessary in either of these countries, assuming that the other country does not change G, to achieve target output? Solve for net exports and the budget deficit in each country. d. What is the common increase in G necessary to achieve target output? e. Why is fiscal coordination (such as the common increase in G in (d) ) difficult to achieve in practice?