Follow the outlined instructions and answer the questions carefully.

For the following you will use the TWO GRAPHS WE HAVE DEVELOPED FOR THE SMALL OPEN ECONOMY (SOE): the graph that links domestic S and I to the global interest rate r*, and the graph that links the NX (X-M) demand function for the small open economy with the real exchange rate.As we have said in lecture, these two graphs say the same thing is different ways.

Okay, SEPARATELY FOR EACH SCENARIO BELOW, START from a position of TRADE ACCOUNT IN BALANCE, (X = M) for the SMALL OPEN ECONOMY.

Now, trace through the impact (using the two graphs for the SOE) for each of the following cases and show:

THE CHANGES IN THE SOE:(1) to the NFI (net foreign investment - or net capital inflow or outflow)? (2) to the position of the small open economy being a borrower or a lender in the international capital markets? (3) to the trade balance (NX)? (4) to what would you normally expect to occur to the relative price levels in the small open economy versus the ROW that would help explain the movements in the two graphs?

(a) A rise in investment demand in the small open economy.

(b) A rise in investment demand in the rest of the world economy (ROW).

(c) A rise in the marginal propensity to consume in the ROW.

(d) A rise in taxes in the small open economy.

(e) A sudden deep economic recession in the ROW.

Now, use the two graphs we have developed - ROW (S,I), and SOE (real FX, NX) to answer the following.

Let's say that an earthquake destroys infrastructure in several important overseas economies (the Rest of the World - ROW). There is no damage to our small open economy. Rebuilding in the ROW causes a surge of investment and economic activity in the ROW.

Now, show and justify what will happen to the real exchange rate and trade balance in the small open economy after this earthquake event. That is, link the dynamic macroeconomic shifts in the two graphs.