Question 1 (20 points) - Topics 5 & 7

Home is a small open economy with perfect capital mobility. Initially, it is in its long-run equilibrium and domestic assets and foreign assets are prefect substitutes. Recently, residents in Home have undertaken many protest (non-violent so far) demanding more freedom and greater say in future decisions. Many believe that this kind of the political unrest might have negative impacts on the economy and people worry that the negative impacts include the following: Making domestic assets become more risky and the risk premium (on domestic assets) becomes positive. (Hint: think about what happens to domestic real interest rate) Lower business confidence.

a) Use the long-run classical model of an open economy to evaluate the people's concerns mentioned above on the country's output, consumption, investment, net exports, real exchange rate, and price level. Explain and support your answer by ONE loanable funds market diagram and ONE foreign exchange market diagram. (15 points).

b) Based on your answer in part (a), is there anything the central bank can to if it wants to offset the effect of the change in risk premium on the country's real interest rate? Explain. (5 points).