This question explores what might happen if China reduces its government spending. Suppose the world consists of two countries, China (home, unstarred) and the US (foreign, starred). There are two time periods, no uncertainty, and no investment spending.

InChina, Y₁ = Y₂ = 80 and in the US Y^*₁ = Y^*₂ = 120. Initially A₀ = 10. In each country, households' consumption satisfieses this Euler equation:

1/C₁= 0.96(1 + r)(1/C₂) and

1/C^*₁= 0.96(1 + r)(1/C^*₂)

(a) If G₁ = G₂ = 20 and G^*₁= G^*₂= 30 then solve for the world real interest rate and for the current account of China in each time period.

(b) If instead G₁ = 18 and G₂ = 20 while again G^*₁= G^*₂= 30 then solve for the world

real interest rate and for the current account of China in each time period.

(c)Would the effect of the 10% reduction in government spending on the world real interest

rate be larger or smaller if (i) it was permanent or (ii) it occurred in the US? (You do not

need to give a numerical answer.)