Consider a small open economy (SOE), which can be described in the long run by the neoclassical model of saving and investment (which implies that prices are perfectly flexible) and the model of net exports. Assume that the world interest rate equals to 4% and the (net) export of capital from this SOE reaches 10 bln.

a) Sketch the situation of this economy on the graphs. Use the two models mentioned above.

b) Now suppose that an important trading partner cancels tariffs on goods exported from this SOE. Sketch the consequences of this policy on the graphs. Use the same models as before.

c) Suppose that this SOE uses a fixed exchange rate regime. Explain the process of equilibrating the balance of payments after the above-mentioned change in trade policy. Explain through which channel the real exchange rate will be changed.