2.1 Consider a long-run model of a small open economy as follows:

Y = Y^f = F(K^f, L^f)= 600

D=C+I+G+CA

C= 20+0.8(YT)

I = 80

G = 150

T = 150

a) Calculate the value of total absorption (A) for this economy and then use that value (along with other information on this economy) to show that this economy has an equilibrium current account deficit (CA< 0) and to calculate the amount of that current account imbalance. Show your work.(4 marks)

b) Calculate the value of national saving (S) for this economy and use that value (along with other information for this economy) to calculate the equilibrium value of net capital flow (NCF) for this economy. State whether this economy is a net foreign borrower or net foreign lender.Show your work.

c) What assumptions about the international market for financial capital ensure that this economy will be able to borrow or lend internationally to the extent required by your calculation in part b) above? Explain.(3 marks)

d) This economy has a current account deficit (CA<0).To exactly eliminate this deficit and create an equilibrium current account balance of zero (CA=0), the government of this economy could either:

i) ____________ (increase/decrease) government purchases (G) from 150 to ___, while holding taxes (T) constant at 150;(2 marks)

^OR

ii) _______ (increase/decrease) taxes (T) from 150 to ___, while holding government purchases (G) constant at 150.(2 marks)

e) Now suppose that the government of this economy is unable to adopt either of the fiscal policy changes, described in part d) because of political opposition and, hence, a current account deficit persists. To consider the longer term consequences of persistent current account deficits, we will make a key amendment to our model. We shall begin by acknowledging that full-employment national income (Y^f) is equal to full-employment Gross Domestic Product (Q^f = F(K^f, L^f) plus net income from the rest of the world (ROW), and then assuming that net income from ROW in each year is equal to the economy's net foreign wealth at the start of that year (NFW) multiplied by the world interest rate (R*> 0), Thus,

Y^f =F(K^f, L^f)+ R*NFW

We can predict that, other things equal, an economy which has an equilibrium current account deficit in one period will experience a(n) _______ (increase/decrease) in net foreign wealth (NFW) resulting, other things equal, in a(n) _______ (increase/ decrease) in national income (Y^f) in the next period.Other things equal, that change in national income will simultaneously produce a(n) _______ (increase/decrease) in absorption (A) which is _______ (larger than/smaller than/ equal to) the change in national income which brought it about, resulting in an _______ (increase /decrease / no change) in the equilibrium current account balance (CA).[Note: In this case an increase in the equilibrium CA implies a smaller current account deficit, while a decrease in the equilibrium CA implies a larger deficit.]