Version:0.9 StartHTML:0000000105 EndHTML:0000009384 StartFragment:0000000141 EndFragment:0000009344 Consider the small open economy of the country of Examnia from the perspective of the

classical model. Examnia's economy is described by the following equations:

Y = 20000

T = 2000

G = 5000

C = 500 + 0.75(Y T)

I = 2000 50r

NX = 400 400( 10)

The notation used here is identical to that used in the course. In particular, refers to the

real exchange rate and r refers to the domestic interest rate (but bear in mind Examnia is a

small open economy with free capital flflows).

(a) Suppose the world interest rate is r

= 5. Based on the information given, answer the

questions below.

i. Calculate the level of domestic investment (I). Show your workings. (2 marks)

ii. Calculate the level of net exports (NX). Show your workings. (2 marks)

iii. Calculate the level of the real exchange rate (). Show your workings. (2 marks)

(b) Suppose the government of Examnia engaged in contractionary fifiscal policy, and

dramatically reduced the level of government purchases.

i. What impact will this have on the domestic interest rate? Brieflfly your answer in

one or two sentences. (1 mark)

ii. What impact will this have on net capital outflflow? Brieflfly explain your answer in

two or three sentences. (3 marks)

iii. Using an appropriate diagram, graphically illustrate the impact of the contractionary

domestic fifiscal policy on Examnia's real exchange rate () and net exports in the

long run (NX). You must also provide a brief written explanation for any shifts

of the relevant curves and changes to equilibrium real exchange rate and net

exports. (8 marks