Part 3 - Problem (50 points) Note: In this problem, it is important to show all your steps.

Consider the following world that consists of two economies:

Home Economy and Foreign Economy. Foreign variables are starred. Assume that both countries either use the same currency, or that the real exchange rate is fixed and normalized to one. C = 10 + 0.6(Y T) I = I G = G T = T Q = 0.1Y X = 0.1Y

1. Solve for the equilibrium income in the domestic economy, in terms of, I, G, T and the output of the Foreign Economy, Y . (5 points)

2. Assume now the following values for investment, government spending and taxes: I = 10, G = 10, and T = 10, find the relationship between the equilibrium output in the domestic economy, Y, and the level of output in Foreign Economy, Y . (5 points)

3. Assume Foreign Economy is identical to Home Economy and has the same equations. Solve for equilibrium output in each economy, Y and Y . (8 points)

4. Assume now that Home Economy wants to achieve a level of output, Y p = 62.5, by changing its taxes, T. While doing so, it assumes that Foreign Economy will not change its fiscal policy (neither G , nor T ). You are asked to find by how much the government in Home Economy must change the taxes level, T, to achieve the targeted level of output? (Note that the levels of investment and government spending in Home Economy remain the same as above. (7 points)

5. What is the impact of the change in the taxes level in Home Economy on:

(a) The deficit in Home Economy? (3 points)

(b) Output and the deficit in Foreign Economy? (3 points)

(c) Each economy's trade balance? (4 points)

6. Assume now that the countries can credibly commit to coordinate fiscal policies.

(a) What is the common change in T that achieves the target level of output for both countries? (4 points)

(b) What is the common level of the budget deficit, and how does it compare with the level when Home Economy took unilateral action? (2 points) (c) What is the trade balance in each economy with coordinated policy? (2 points)

7. Why is such coordination difficult to achieve in practice? (7 points)