Suppose that policymakers in Mexico, a small open economy with aflexibleexchange rate, want to raise the level of domestic investment (I)withoutchanging net exports (NX=0). What is the combination of (a)foreignfiscal policy and (b)domesticmonetary policy that would achieve this goal? Goal: I and NX=0

Answer the following questions in this specific order. Read all of them before answering.

a) What is theforeign fiscal policythat would increase Mexican investment in capital goods? Explain how thisforeignfiscal policy would affect the world market for loanable funds and the world interest rate (r*). Assume that a LOE, such as the U.S., can be convinced to implement your policy choice.

Would the change in r* create net capital inflow (NCI) or a net capital outflow (NCO) for Mexico? Use the net capital flow equation to explain.

NCF = [Amount that Mexico lends abroad]-[Amount foreigners lend to Mexico] = 0

Would the NCI or NCO appreciate or depreciate the value of the Mexican peso? Explain the changes in the demandandin the supply of pesos in the foreign exchange market. Assume that e = US$/Peso.

How would the appreciation/depreciation of the Peso change net exports and real GDP? Explain carefully the change in real GDP.

b) What is theMexicanmonetary policythat would keep net exports unchanged? Explain your choice.