Question 2 (20 points) - Chapters 4 & 5

Home is a small open economy that can be described by the long-run classical model:

Consumption: C = 11250 + 0.75(Y - T) - 2000r

Investment:I = 16500 - 1500r

Government spending:G = 12000

Net exports:NX = 5000 - 4400e_FC/DC, e_FC/DC = real exchange rate

Real money demand:L(r + p^e, Y) = 0.65Y - 200(r + p^e)

(Nominal) money supply:MS = 18000

Foreign price level:P_F = 1.5

World interest rate:r^w = 6%

Suppose the money supply in both the Home and Foreign countries has been growing by 5% per year for the past several years and this is expected to continue.

Note: Both r and p^e are measured in percentage points (for example, if we find r = 10, then r is interpreted as being equal to 10%). Keep your answer to at least 4 decimal points.

a)Initially, the government of Home runs a budget surplus of 3000 with an equilibrium (real) exchange rate is 1.25 FC per DC.Find the long-run equilibrium levels of output, national saving, net exports, and price level for Home.Find the equilibrium nominal exchange rate. (5 points)

Home is initially in its long-run equilibrium as described in part (a).Suppose the fear of a terrorist attack inside of the Home country's borders causes Home's autonomous net exports to change by 22%.

b)Find the new long-run equilibrium levels of output, national saving, net exports, price level, and real exchange rate. (5 points)

NX_new

c)Suppose politicians in the Home country find the change(s) in part (b) undesirable, and pressures to the government to permanently double the rate of growth of the money supply.Determine the resulting new growth rates of the real and nominal exchange rate for the Home country currency. Describe in words the impact this has on Home's net exports and level of output in long-run equilibrium. (5 points)

d)Suppose instead, the changes of part c have not occurred, but rather these fears have not only caused Home's autonomous net exports to change by 22%, but it also causes Home's autonomous investment to rise by 20%, as the government realizes the country needs to invest more in domestic security infrastructure. Find the new long-run equilibrium levels of output, national saving, net exports, price level, and real exchange rate. (5 points)