# Instructions: Please show all work or points will be taken off. Good luck! 1. (45 points total) We assume…

Instructions: Please show all work or points will be taken off. Good luck! 1. (45 points total) We assume that the world consists of two large open economies, USA and China. USA Initial Conditions Cd = 300 + 0.4(Y-T) – 200rw Id = 150 – 200rw Y = 1000 T = 200 G =325 China Initial Conditions CdF = 480 + .4(YF – TF) – 300rw IdF = 225 – 300rw YF = 1500 TF = 300 GF = 300 a) What is the equilibrium interest rate that clears the international goods market? Show all work (10 points). b) Now calculate the levels of desired savings and investment for each country at this equilibrium world real interest rate (5 points). c) Which country is ‘spending beyond its means’ and which country is the saver? What exactly do we mean by the phrase ‘spending beyond its means’ in this context. Be sure to define and use the word absorption in your answer and compare the level of absorption in each country to its income. Explain (5 points). Draw two diagrams side by side, with the US on the left and the China on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagram completely. 10 points for correct and completely labeled diagrams Now China experiences an adverse productivity shock. As a result, China’s output falls to 1400. d) (10 points) Resolve for the world real interest rate that clears the international goods markets along with the ‘new’ Sd and Id for each country and add these results to your diagram labeling this new equilibrium as points B (there are four of them!). (10 points) e) (5 points) Now comment on what has happened to the trade balance for each country and relate to the movie clip from Colbert about spending beyond our means. Recall that Fareed Zakaria (the guest) suggested that we (the US) needed to go to alcoholics anonymous (AA). Are your results consistent with the US going to AA? Why or why not? Explain and please be specific.. 2. (40 points total) We assume that the world consists of two large open economies, home and foreign. Home Country Initial Conditions Cd = 490 + 0.4(Y-T) – 300rw Id = 350 – 300rw Y = 1500 T = 300 G =200 Foreign Country Initial Conditions CdF = 480 + .4(YF – TF) – 200rw IdF = 350 – 200rw YF = 1500 TF = 300 GF = 200 a) (5 points) What is the equilibrium interest rate that clears the international goods market? Show all work. b) (5 points) Now calculate the levels of desired savings and investment for each country at this equilibrium world real interest rate. c) (5 points) Which country is acting like the US (i.e., spending beyond its means) and which country is acting like China (i.e., the saver)? You must use and define absorption to get full credit. Draw two diagrams side by side, with the Home country on the left and the Foreign country on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagram completely. 10 points for correct and completely labeled diagram Now the home country conducts expansionary fiscal policy so that G rises by 50 to now equal 250. All else remains the same. d) (5 points) Resolve for the world real interest rate that clears the international goods markets and add these results to your diagram labeling this new equilibrium as points B (there are four of them!). (5 points) e) (5 points) What has happened to the trade balance for the home country and did the increase in G ‘crowd out’ private investment? If so, how much investment was crowded out? g) (5 points) Now let’s pretend that the Government spending multiplier is 1 so that the increase in G by 50 resulted in Y rising by 50 (from 1500 – 1550) Resolve for the trade balance for each country. Are these final results consistent with the home country going to AA, the proposition put forth by Fareed-Zakaria in the Colbert clip (why or why not)? Please DO NOT add these results to your diagram, just discuss them! (please don’t ask us what going to AA means, we talked about it numerous times in the lesson)

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