Policy coordination and the world economy

Consider the following open economy. The real exchange rate is fixed and equal to one. Consumption, investment, government spending and taxes are given by:

C = 10 + 0.8(Y - T); I = 10; G = 10; T = 10

Imports and exports are given by

IM = 0.3Y; X = 0.3Y*

where an asterisk denotes a foreign variable.

a. Solve for equilibrium output in the domestic economy, given Y*. What is the multiplier in this economy? If we were to close the economyso exports and imports were identically equal to zerowhat would the multiplier be? Why are they different? (4 marks)

b. Assume that the foreign economy has the same equations as the domestic economy (with asterisks reversed). Use the two sets of equations to solve for the equilibrium output of each country. What is the multiplier for each country now? Why is it different from the open economy multiplier above? (4 marks)

c. Assume that both countries have a target level of output of 125. What is the increase in G necessary in either of these countries, assuming that the other country doesn't change its level of government spending, to achieve target output? Solve for net exports and the budget deficit in each country. (4 marks)

d. What is the common increase in G necessary to achieve target output in both countries? (2 marks)

e. Why is fiscal coordination (such as the common increase in G in [d]) difficult to achieve in practice? (2 marks)