Consider a small open economy that initially has a trade surplus.

a) Draw a diagram illustrating this economy's foreign-currency exchange market. Be sure to label the axes, curves (with the subscript ₁) and equilibrium values (with the subscript ₁).

b) Assume that two changes have occurred: the government has eliminated all tariffs on imports and cut taxes. As a result of these changes, the small open economy's real exchange rate has appreciated. On the same diagram as part a, illustrate these changes to the economy's foreign-currency exchange market. Be sure to label the curves and new equilibrium values (each with the subscript ₂).