Suppose the economy of Canada has reached the long run equilibrium (i.e. full employment) and assume that the functions of exports and imports are as follows:

=0+1+2()

=01+2()

where is the real exchange rate between Canadian and US goods, is the Canadian disposable income, is the US (foreign) disposable income, and the 's and the 's are positive numbers (parameters).

Assume that Prime Minister Trudeau decides to implements atemporarypolicy that convinces Canadians to buylessimported goods at any given real exchange rate and any given level of domestic disposable income. In particular, assume that this policy lowers 0 in the imports function shown above.

a) (3 points) Explain how this shock affects the trade balance (i.e., the difference between exports and imports). Does the trade balance improve (rise) or deteriorate (fall) after the shock? Briefly explain why. Use the two equations presented above to support your answer.

b) (5 points) Use theKeynesian Cross diagramto show if this shock shifts the aggregate or not. If the shock shifts the aggregate demand, show graphically if the demands shifts up or down and how this affects the level of output. Do not forget to explain why the level of output changes.

c) (10 points) Explain how this temporary shock affects the level of output, consumption, investment, government expenditure, the nominal interest rate, the nominal and real exchange rates, and the level of prices in the short run. Use the AA-DD model to answer this question and do not forget to use an AA-DD diagram to support your answer. Explain why the curves shift and why the variables change.

d) (10 points) Explain what type of monetary policy, contractionary or expansionary, does the Central Bank have to implement to move the economy back to full employment (i.e., the initial equilibrium)? Support your answer with a graph of the AA-DD model. Explain why the curves shift and why the variables change.