3. Open Economy

Consider an economy where

C = 200 + 0.25(Y-T)

I = 200 + 0.25Y-1000i

G = 350, T = 300 i=i=.05

X = 0.4Y* and IM = 0.2Y,

(real exchange rate) = 2

Y* (foreign output) = 1000

a. Calculate the multiplier if the economy is closed and the multiplier if the economy opens up. Explain the economic intuition why the two are different with 3-5 sentences.

b. Solve for the equilibrium level of income (Y) for the open economy (Yopen) and calculate the trade balance (NX).

c. If government follows an expansionary fiscal policy and G changes by 60, calculate the change in Y for both the closed economy (Yclosed) the open economy (Yopen). Assume no change in the foreign output (Y*). Calculate the new trade balance.

d. If this economy has flexible exchange rate regime, how would the exchange rate respond to a fiscal expansion policy? Appreciation or Depreciation? Explain why.

e. Suppose the interest rate in the foreign economy is 2%, and an investor expects the domestic currency to depreciate relative to the foreign currency by 4%, in which bond market in those two economies should the investor invest?