Suppose there are only two countries in the world, Foreign and Home. Foreign is a large country while Home is small country. Currently, Home runs a huge trade deficit. Concerning about the country's trade balance, the government of Home begins to look for policy that can correct its trade deficit. The Home government asks you for recommendation. In addition, the Home government wants you to use the long-run classical model of a small open economy to evaluate the long-run effects of your recommended policy on the Home's key macroeconomics variables (output, national saving, investment, real interest rate, net foreign investment, net exports, real exchange rate, nominal exchange rate, price level, and unemployment rate). What policy would you recommend? What happens to the key macroeconomic variables in the long run? Explain and support your answer by a set of appropriate diagrams. Note: You must provide explanation on how your recommended policy affects the key variables (explain why the variables change or remain unchanged).

answer:

Recommended policy: contractionary fiscal policy. No change: Y, I, r, P and unemployment rate. Increases: S, NFI, NX DC depreciates in both real and nominal term