1. Openness in the Goods Market (19 Points)

Let us consider a domestic open economy described as follows:

C = 10 + 0.5(Y-T)

IM/e = 0.2Y

I = 3 + 0.3Y

X = 0.3Y*/e

G=10

where e stands for the real exchange rate defined as the price of one unit of the domestic good in terms of foreign goods and Y* stands for the foreign output/income. The government budget deficit is equal to 2% of the domestic output/income denoted by Y.

a. Write-down the budget constraint of the government for the above domestic economy. (2 Points)

b. Using the characteristics of the above domestic economy and your answer to a, write down the equation of the aggregate domestic demand for domestic goods schedule (AA) and the equation of the aggregate demand for domestic goods schedule (ZZ). (4 Points)

c. Write down the equation of the net exports schedule (NX) for the above domestic economy. Does the Marshall-Lerner condition hold? (4 Points)

d. Write down the domestic goods market equilibrium condition. Solve for the domestic equilibrium output/income Y given Y* and e. (3 Points)

e. Under the assumption that the foreign output/income expressed in terms of the domestic goods is half the size the domestic output/income, compute the equilibrium domestic output/income. (4 Points)

f. Does the domestic economy run a trade surplus or a trade deficit in equilibrium? (2 Points)