(Q1)

Suppose the government decides to reduce spending and (lump-sum) income taxes by the same amount. Use the long-run classical model of the economy to graphically illustrate the impact of the equal reductions in spending and taxes. State in words what happens to the real interest rate, national saving, investment, consumption, and output.

(Q2)

Consider a small open economy described by the following equations:

Y = C + I + G + NX,

Y = 5,000,

G = 1000, T = 1000,

C = 250 + 0.75(Y - T)

I = 1000 - 50r,

NX = 500 - 500 ,

r = r* = 5,

where is the real exchange rate and r* is the world interest rate.

a. In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate.

b. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.

c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1000). Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.