Question 1 (20 points: 10 points for each part, A & B) - Chapter 3 & 6

Suppose you are an economic expert who works as an economic analyst in a small open economy (SOE) that presently has perfect financial capital mobility and no risk premium. The government of a large open economy (LOE) is considering adopting one of the following economic policies:

1) A subsidy geared to the construction of investment within the economy of the LOE; or

2) An increase in taxes to help lower the government budget deficit of the LOE.

Draw a pair of diagrams, one for the domestic loanable funds market of the SOE and one for the market for foreign exchange, that depict the impact of the proposed LOE polices on the SOE (i.e. two sets of two diagrams in total).

a) Suppose you are hired by the association of homebuilders of the SOE. Use your diagrams to provide an analysis of the impact of each potential LOE policy on their industry. In your expert opinion which potential LOE policy is most preferred (by this group)? Explain why. Which policy is less preferred (by this group)? Explain why.

b) Suppose instead, you are hired by the association of importers of the SOE. Use your diagrams to provide an analysis of the impact of each potential LOE policy on their industry. In your expert opinion which potential LOE policy is most preferred (by this group)? Explain why. Which policy is less preferred (by this group)? Explain why.