Home is a small open economy while Foreign is a large open economy, and Home has a flexible

exchange rate. Besides, both countries are in their long

-

run equilibrium.

Now, to lower its

budget deficit, the Foreign government lowers its spending.

Note: For both parts, you must provide explanations why the variables of interest change or

remain unchanged in order to receive any credit.

a)

Use the

Mundell

-

Fleming

model (Y

-

r graph) to illustrate graphically and explain in words

the short

-

run effects of this change on Home's output, net exports, real exchange rate,

nominal exchange rate, and real money balance. Only the first diagram will be graded. (10

points)

b)

Use the

long

-

run classical model of a small open economy to show, in graphs and words, the

long

-

run effects this change on Home's output, net exports, real exchange rate, nominal

exchange rate, and real money balance. (10 points)