Problem 2 - Midterm 2014: Chile is a small open economy in the international market for funds that takes the real interest rate in the world funds market, rw, as given. Further, Chile has a current account deficit since 2011, CAC < 0. On February 10th the presidents of the Pacific Alliance countries (Chile, Colombia, Mexico and Peru) signed an agreement on which Chilean President Sebastian Pinera commented: "We have just reached an agreement to liberalize trade between the four countries for 92 percent of the goods, and we are going to reach 99 percent in three to seven years."

Using Chile's market for funds graph and assuming that it is a permanent productivity shock, illustrate the effect of the agreement on Chile's amount of national saving, amount of national investment, and current account balance. Now suppose a pessimistic economist appears and says that the Chilean President is too optimistic and that the trade agreement will not affect the economy immediately but after an adjustment period in the future. In other words, the productivity shock does not affect the current period but the future period and would be a temporary shock in the future. b) Illustrate the effects of this agreement as a future temporary productivity shock in a graph for the funds market. c) What would be the effects of this agreement as a future temporary productivity shock on Chile's current account balance, CAC ? Include the current period effects on current employ- ment, N , the current real wage, w, current domestic consumption, C, amount of current domestic saving, S, amount of current domestic investment, I, and current net exports, N X.