1. Part 1
Consider an open economy in which the real exchange rate is fixed and equal to one. Consumption, investment, government spending, and taxes are given by C = 10 + 0.8(Y-T), I = 10, G = 10, and T = 10 Imports and exports are given by IM = 0.3Y and X = 0.3Y* where Y* denotes foreign output.

a. Solve for equilibrium output in the domestic economy, given Y *. What is the multiplier? In this economy, if we were to close the economy so exports and imports were identically equal to zero. What would the multiplier be? Why would the multiplier be different in a closed economy?

b. Assume that the foreign economy is characterized by the same equations as the domestic economy (with asterisks reversed). Use the two sets of equations to solve for the equilibrium output of each country. [Hint: Use the equations for the foreign economy to solve for Y * as a function of Y and substitute this solution for Y * in part (a).] What is the multiplier for each country now? Why is it different from the open economy multiplier in part (a)?

c. Assume that the domestic government, G, has a target level of output of 125. Assuming that the foreign government does not change G*, what is the increase in G necessary to achieve the target output in the domestic economy? Solve for net exports and the budget deficit in each country.

d. Suppose each government has a target level of output of 125 and that each government increases government spending by the same amount. What is the common increase in G and G* necessary to achieve the target output in both countries? Solve for net exports and the budget deficit in each country.

e. Why is fiscal coordination, such as the common increase in G and G* in part (d), difficult to achieve in practice?

Part 2

Eliminating a trade deficit
a. Consider an economy with a trade deficit (NX <0) and with output equal to its natural level. Suppose that, even though output may deviate from its natural level in the short run, it returns to its natural level in the medium run. Assume that the natural level is unaffected by the real exchange rate. What must happen to the real exchange rate over the medium run to eliminate the trade deficit (i.e., to increase NX to 0)?
b. Now write down the national income identity. Assume again that output returns to its natural level in the medium run. If NX increases to 0, what must happen to domestic demand (C + I + G) in the medium run? What government policies are available to reduce domestic demand in the medium run? Identify which components of domestic demand each of these policies affect.