Consider the following open economy. Consumption, investment, government spending, and taxes are given by:

C= 500 + 0.5YD I= 550 - 2000i + 0.2Y G=400 T=500 Imports and exports are given by:

Q= 0.3Y - 100 X= 0.2Y* + 100 Where an asterisk denotes a foreign variable. Suppose i = 0.05 and real exchange rate is fixed and

equal to one.

Solve for equilibrium income in the domestic economy, given Y*. What is the multiplier in this

economy? If we were to close the economy (so that exports and imports were equal to zero), what

would the multiplier be? Why are the two multipliers different? (7 points)

Assume the foreign economy has the same equations as the domestic economy (remove the asterisk from all the variables with an asterisk, and add an asterisk to all the variables without an asterisk). Assume both countries have a target level of output of 4000. What is the increase in G necessary in either of these countries, assuming that the other country does not change G, to

achieve target output? Solve for net exports and the budget deficit in each country. (8 points)

What is the common increase in G necessary to achieve target output? Solve for net exports and

the budget deficit in each country. (5 points)

Use your answers in (b) and (c) to explain why fiscal coordination is difficult to achieve in

practice. (4 points)