In this matter we will relax the hypothesis of small open economy. Specifically, the domestic country now affects demand goods from the foreign country, via their imports - which impact foreign exports, which again affect the demand for domestic goods, and so on.

Suppose the consumption, imports and exports functions for the domestic country are given by:

C = c₀ + 0.6Y

IM = 0.4Y

X = 0.4Y*

In the foreign country, the structure is symmetrical:

C* = c₀ + 0.6Y*

IM* = 0.4Y*

X* = 0.4Y

Assume zero taxes in both countries. In addition, investment (I, I*) and government consumption (G, G*) in both countries are

exogenous, and the real exchange rate is equal to 1.

What is the tax multiplier in the domestic country?

Hint: The correct answer is: 1.67. Demonstrate the calculations used