Page 2 SECTION A: Answer ALL questions 1. Open Economy and Trade (a) Indicate whether the following statement is true, false, or uncertain and explain your answer using words, graphs and equations as appropriate. (i) In a classical small open economy, if net capital outflow is positive, then the trade balance must also be positive. (ii) The adoption of an investment tax credit in a classical small open economy is likely to lead to an increase in domestic investment and a fall in the exchange rate. (ii) In a Keynesian small open economy with a fixed exchange rate, an effective policy to increase equilibrium output is to increase the money supply. (15 marks total) (b) Consider a classical economy. Assume that the GDP of an economy is 9000. Consumption is given by the equation C = 600 + (3/4)YD - 40r, where r is the percentage real rate of interest. Investment is given by the equation / = 1200 - 120r. Net exports is given by NX = 1500 - 2006. There is a budget deficit of 500 and government spending is 1500. Finally, suppose the world interest rate is 5. (i) For this open economy derive all equilibrium values, all savings values, and also describe whether the current and capital accounts are in deficit or surplus. (ii) Suppose the government wants the currency to depreciate. What actions should it take (and briefly explain why based on part (i).) Graphically illustrate equilibrium in this economy both before and after the government's actions. Question 1 continued on next pagePage 3 Now consider the Mundell-Fleming Model. Suppose that net exports in the UK are given by the following equation: NX = NX(6, Y*), where Y' is foreign income. (iii) If the foreign country enacts expansionary fiscal policy, briefly explain and illustrate the impact on the UK's income, exchange rate, and the trade balance under floating exchange rates. I (iv) If the foreign country enacts expansionary fiscal policy, briefly explain and illustrate the impact on the UK's income, exchange rate, and the trade balance under fixed exchange rate. (35 marks total)