Consider an economy characterized by the following equations for consumption (C), investment (I), government spending (G), the tax level (T), net exports (NX), domestic output (Y), foreign output (Y* ), the domestic policy rate (i), the inflation rate (), and the exchange rate (E):

• C = 400 + 0.5(Y - T)
• I = 80 + 0.1Y - 1000(i - e + x)
• NX = 0.01Y* - 0.1Y - 4(E - 100)
• G = 600
• T = 480
• Y* = 20,000

Suppose the central bank has successfully anchored inflation expectations at the target inflation rate of (= 0.02 =) 2%, so: e = 0.02. The borrowing rate faced by households and businesses includes a risk premium of 4% over the policy rate i, so: x = 0.04. Moreover, suppose the central bank has set the policy rate equal to 2% (this is, = 0.02). The foreign interest rate is also 2% (i * = 0.02). The exchange rate (E) is 100, and the expected future exchange rate is also 100.

a) Find the short-run equilibrium level of output () and trade balance (). Does this economy have a trade deficit or a trade surplus?

b) Suppose the government decides to cut the tax level to = 400. Find the new shortrun equilibrium level of output ( ) and trade balance (X ). Would it be accurate to refer to this economy as one suffering from twin deficits (budget deficit and trade deficit)? Why or why not? If so, what policy change could help get rid of both deficits?

c) What is the value of the fiscal multiplier from the tax cut? Would it be greater or smaller if this were a closed economy? Explain the intuition for this result. Suppose that, before the tax cut, this economy was at potential (i.e., zero output gap).

d) Explain intuitively (a qualitative answer will suffice) what effects the tax cut in (b) will have on investment and on the trade balance in the medium run. Use the appropriate model to justify your answers.