Suppose that a developing country with a fairly large population invests a great deal in improving manufacturing capacity of goods that will be sold to the US. We could model this change as a sudden increase in foreign TFP along with an increase US demand for imports. Use the open economy IS-LM model to answer the following questions.

A.Using well labeled diagrams of the foreign goods market and foreign IS-LM, show how a sudden increase in foreign TFP along with a large increase in US demand for foreign goods and services will affect the foreign economy. Both of your diagrams should begin in a long run equilibrium labeled A. Shift the appropriate curve(s) to represent the two changes described above and label the new equilibrium B. What does the model indicate will happen to output, the real interest rate, and net exports for the foreign country in the short run (assuming sticky prices). Explain all of the economic forces that affect each curve that you shift.

B.Using the supply and demand model of exchange rates, analyze the effect of the changes described above on the foreign currency price of the US dollar. Label the initial equilibrium A and the new short run equilibrium B. Briefly explain all of the factors that contribute to curve shifts.

Finally, analyze the impact of the changes described above on the US economy using the IS-LM diagram. The initial equilibrium should be labeled A and the new short run equilibrium should be labeled B. What is the likely impact to domestic output, real interest rate, investment, and net exports